As previously disussed in the Basic Option Definitions chapter, you have to pay a premium to purchase a contract.
So to just recap: By purchasing a CALL contract you have the rights to “Purchase a stock at a predetermined price on or before a predefined date” for a PUT Contract, you the the rights to “Sell a stock at a predetermined price on or before a predefined date“.
make sense? here’s an easy way to remember it:
CALL up, PUT down…
If you’re going to buy a call, you expect the stock price to go up in the future.
If you are purchasing a put contract, you expect the stock price to go down in the future.
Now that is the easy part… now, not all options contracts are equal…
Contracts can have 3 status’s… they can be In the money, At the Money, or Out of the Money. The further in the money the options are (meaning their strike price is in the money), then the more expensive the option is. The other element or force that determines the options value is it’s time value, or time to expiration)…
lets explore each of these elements in more detail:
Imagine a game of throwing a ball through a basketball hoop. If you stand Underneath the hoop you have almost a certain chance of scoring. But the value of that score very small.
Take a few steps back, and imagine now you score a little more, but your chances of scoring reduce slightly.
now step back a few steps more, once again your chances of scoring diminish, but your reward increases for when you score
Options trading take on a very similar risk to reward ratio as our game of shooting hoops… the further in the money your options are, the more likely they are to expire ‘In the money’ and successful for you… HOWEVER the rewards for these options are very low, and for deep in the money options, your reward is basically wiped out by brokers fees… so we basically NEVER BUY deep in the money options. The only ‘In the money’ options that you should ever buy are SLIGHTLY IN THE MONEY options. so we can maintain an acceptable reward.
Conversely, if you go for Deep out of the money options, you’ll be standing over the 1/2 way line trying to shoot hoops. how likely is it that you will make a score from the 1/2 way point? not likely? so too are you to be not very likely with purchasing deep out of the money options. However, if you do and you are successful, then your reward will be great.
For this reason, to take an acceptable risk reward ratio with every position, you should concentrate on AT THE MONEY options.. they are options that have a stike price that is as close to the underlying asset price as possible.
In the money options:
an in-the-money option is the most expensvie option. the more ‘in the money’ it is, the more expensive the option becomes.. so much so that an option will have a 1 to 1 ratio value for each dollar that it is in the money.
At the money options:
these are the most popular options to purchase. they are either slightly in the money or slightly out of the money options. They have all the characteristics of the underlying asset however do not posses any significant costs and provide the best risk / reward ratio of all of the options. You can gett a deeper understanding of why when you discover the ‘greeks’.
Out of the money options:
Out of the money options are for the true gamblers. the ones that chase the massive returns with little or no chance of ever realizing a profit. I would consider these to be too much of a gamble to be traded actively by seasoned traders, however, there are strategies and circumstances that can bring these option types to life!