Options are misunderstood (or not understood at all) by most investors. Options are opportunites to make buy and sell decisions down the road - if the market is cooperative. Options can also be used as a method of raising additional yield from your portfolio.

All right, your eyes are glazing over and your mind is starting to shut down. Before your begin snoring, see if this helps you understand options.

Suppose your wealthy Uncle Bob just died and left you $100,000 in his will. The attorney for Uncle Bob's estate estimates that you will have the funds within six months as the estate is distributed. As it happens, your neighbor across the street is putting his house on the market and you have always loved that house and thought if you ever got the chance, you would buy it. Now you have the opportunity, but you won't have the money for six months.

So you go and talk to your neighbor, and he agrees to give you the right to buy his house for $100,000 at any time in the next six months, and in exchange for this you agree to give him $5,000 for that right. Whether or not you buy the house, he gets to keep the $5,000. If the estate settles on time and you get your money, you buy the house and your total cost is $105,000 ($100,000 purchase price plus the $5,000 'premium' paid for the right). If the real estate market collapses and the house is now only worth $70,000, you would let your neighbor keep the 'premium' and you wouldn't 'exercise' your right to buy at $100,000. It's your call.

Now substitute some stock (like IBM) for 'house' and you understand how options work. Buying an option gives you the right to buy (or sell) a specific instrument at a set price within a preset time period. Once you own the right, it is up to you whether or not to exercise your right.


An option is simply a contract involving a buyer willing to purchase specific rights and a seller willing to grant those rights in return for the premium. Unlike shares of stock, there is no fixed number of option contracts. The number of option contracts is determined by how many buyers and sellers agree to the price for an option contract.

Exchange-traded options are standardized in their terms and performance of both parties is guaranteed by the Options Clearing Corporation. By standardizing the terms, exchange-traded options have features which include:

1. Ease of Trading
   - A central marketplace matching buyers and sellers.



2. Secondary Market
   - The majority of options contracts are closed out before expiration by buying or selling the contract in the secondary market. A very small percentage of options contracts are held to expiration or exercised.



3. Sales Recorded
   - Since it is required that all sales must be recorded, the buyer (or seller) of an option contract promptly knows the price at which the order has been executed.



4. Bid/Ask Provided
   - The current bid and offer for each series of options is always available when the contract is trading.



5. Listings in Daily Newspapers
   - Closing prices and other pertinent information are provided by the exchanges to newspapers daily.

The particular item that an option contract controls is called the underlying instrument. Options trade on many underlying instruments including individual stocks, various stock and bond market indices, currencies, and Treasury bills and bonds. At BestVest, we deal in only the equity options representing individual stocks, and index options. Due to the increased risks associated with trading options, you must apply specifically to trade options and demonstrate both the understanding of options trading and the financial capacity to incur potential losses. Options have no loan value and therefore cannot be purchased on margin. Furthermore, options trading requires that cleared funds must be on deposit in the account before any option order will be accepted.

Options trade at a specific strike (or exercise) price. This is the dollar price per share on a stock option or the level of the underlying index on an index option. Thus, the strike price is the price per unit at which the buyer of an option may purchase (if a call option is held) or sell (if a put option is held) the underlying security upon exercise. Strike prices are set by the exchanges, and are typically set at 2 1/2 point intervals for stocks selling below $25 per share, 5 point intervals for stocks selling below $200 per share, and 10 point intervals for stocks trading above $200. These are rough guidelines, the exchanges can and do introduce strike prices to enhance liquidity of the options contracts.

When trading is introduced for a new expiration month, the initial exercise prices normally bracket the stock (or index) price. For example, if A Better Corporation (Symbol: ABC) was trading at 47 3/8 at the end of January, the October ABC options would probably be introduced with exercise prices of 45 and 50. Changes in the price of the underlying security may trigger the creation of additional series of options. The additional series would reflect those stock price movements for one or more of the expiration months for which options on that security are already being traded.


Typically, an equity option contract (that where the underlying instrument is an equity security or stock) covers 100 shares of the indicated security. Thus the buyer of an ABC July 45 call option has the right (but not the obligation) to buy 100 shares of ABC stock at $45 per share or $4,500 anytime until the expiration date of the contract in July. Conversely, until the expiration date in July the seller of the option is obligated, upon exercise, to deliver 100 shares of ABC for which he will be paid $45 per share, regardless of the price of ABC in the marketplace at that time.


The buyer of a call option has purchased the right to buy the number of shares (or other units) of the underlying security at the stated exercise price. Thus, the buyer of 1 ABC May 40 call option contract has the right to purchase 100 shares of ABC common stock at $40 per share, or a total of $4000 dollars. The buyer may exercise that right at any time prior to the fixed expiration date in May. The buyer exercises his rights by notifying his broker prior to their exercise cut-off time for that expiration date. All calls covering ABC stock, as in the example above, are referred to as an "option class." All options of the same class having the same exercise price and expiration date are referred to as an "option series". Thus all ABC May 40 calls would be an individual option series.


The buyer of a put option has purchased the right to sell the number of shares (or other units) of the underlying security at the stated exercise price. To sell the underlying stock at the stated exercise price, the holder must notify his broker prior to their exercise cut-off time for that expiration date. All puts covering one security are referred to as a separate class of options.

	Call	Put
Buy	The right to buy the underlying item at the strike price until the expiration date.	The right to sell the underlying item at the strike price until the expiration date.
Sell	Selling the right to buy the underlying item from you at the strike price until the expiration date. Known as writing a call.	Selling the right to sell the underlying item to you until the expiration date. Known as writing a put.

If the issuer of the underlying security effects a stock split or declares a stock dividend or other distribution (other than an ordinary cash dividend paid out of earnings and profits), the option rules provide for adjustments in the terms of the option contracts covering that security.

Stock Split - Where stock distribution results in the issuance of one or more whole shares for each existing share of the underlying stock, the number of shares covered by an option contract is not changed. However, the number of option contracts is proportionately increased, while the exercise price of those contracts is proportionately decreased. For example, ABC declares a 2 for 1 stock split. The owner of an ABC October 100 call option would now hold 2 ABC October 50 call options.

Where the above conditions are not met (such as in a 3 for 2 stock split), after adjustment the option covers a proportionately greater number of shares of the underlying stock, while the exercise price is proportionately decreased. For example, if a 3 for 2 stock split was declared by ABC. the owner of an ABC July 60 call option, which originally covered 100 shares, would, after adjustment, own an ABC July 40 call option which controlled 150 shares. The dollar amount covered remains the same (60 times 100 equals $6,000 and 40 times 150 equals $6,000).

Stock Dividend - On the ex-dividend date, the number of shares covered by an option is increased in proportion to the stock dividend. The exercise price per share, however, is decreased proportionately in order that the money required to exercise the contract remains as constant as possible both before and after the ex-dividend date. All adjustments in the number of shares are rounded to the nearest whole share, and adjustment of the exercise price is rounded to the nearest 1/8th dollar. Suppose ABC stock declared a 10% stock dividend. Option holders of ABC July 25's after adjustment would hold ABC July 22 3/4 covering 110 shares. Remember that premiums on options are quoted on a per share basis. Thus if the premium in this case were $5, one option contract would cost the buyer $550, or $5 times 110. The original value of the option contract was $2,500 (100 times $25), After adjustment, the value of the contract is $2,502.50 (110 times $22.75).

Cash Dividend - Exercise prices of options are not affected by the payment of an ordinary cash dividend. Cash dividends are considered the property of the owner of the stock on ex-dividend date. The holder of a call option will not receive the dividend on the underlying stock on ex-dividend date.


The final date on which an option may be exercised is referred to as the expiration date. Options technically expire on the Saturday immediately following the third Friday of the expiration month, regardless of whether that Friday is a business date or not. However, it is the customer's sole responsibility to notify TradeStar Investments, Inc.of his intent to exercise by the close of trading of the option series owned. This means tht if you own an option and you wish to exercise it, you must notify the brokerage firm by the close of the market trading on the business day before the option actually expires.