An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the American and European. An American (or American-style) option is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-Style. All stock options are American style. A European (or European-style) option is an option contract that can only be exercised on the expiration date. Futures contracts (i.e., options on commodities; see the article elsewhere in this FAQ) are generally European-style options.

Every stock option is designated by:

• Name of the associated stock
• Strike price
• Expiration date
• The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts. We’ll cover calls first. In a nutshell, owning a call gives you the right (but not the obligation) to purchase a stock at the strike price any time before the option expires. An option is worthless and useless after it expires.

People also sell options without having owned them before. This is called “writing” options and explains (somewhat) the source of options, since neither the company (behind the stock that’s behind the option) nor the options exchange issues options. If you have written a call (you are short a call), you have the obligation to sell shares at the strike price any time before the expiration date if you get called.

Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00. Translation: this is a call option. The company associated with it is IBM. (See also the price of IBM stock on the NYSE.) The strike price is 90. In other words, if you own this option, you can buy IBM at US$90.00, even if it is then trading on the NYSE at $100.00. If you want to buy the option, it will cost you $2.00 (times the number of shares) plus brokers commissions. If you want to sell the option (either because you bought it earlier, or would like to write the option), you will get $2.00 (times the number of shares) less commissions. The option in this example expires on the Saturday following the third Friday of October in the year it was purchased.

In general, options are written on blocks of 100s of shares. So when you buy “1″ IBM Oct 90 Call at $2.00 you actually are buying a contract to buy 100 shares of IBM at $90 per share ($9,000) on or before the expiration date in October. So you have to multiply the price of the option by 100 in nearly all cases. You will pay $200 plus commission to buy this call.

If you wish to exercise your option you call your broker and say you want to exercise your option. Your broker will make the necessary requests so that a person who wrote a call option will sell you 100 shares of IBM for $9,000 plus commission. What actually happens is the Chicago Board Options Exchange matches to a broker, and the broker assigns to a specific account.

If you instead wish to sell (sell=write) that call option, you instruct your broker that you wish to write 1 Call IBM Oct 90s, and the very next day your account will be credited with $200 less commission. If IBM does not reach $90 before the call expires, you (the option writer) get to keep that $200 (less commission). If the stock does reach above $90, you will probably be “called.” If you are called you must deliver the stock. Your broker will sell IBM stock for $9000 (and charge commission). If you owned the stock, that’s OK; your shares will simply be sold. If you did not own the stock your broker will buy the stock at market price and immediately sell it at $9000. You pay commissions each way.

If you write a Call option and own the stock that’s called “Covered Call Writing.” If you don’t own the stock it’s called “Naked Call Writing.” It is quite risky to write naked calls, since the price of the stock could zoom up and you would have to buy it at the market price. In fact, some firms will disallow naked calls altogether for some or all customers. That is, they may require a certain level of experience (or a big pile of cash).

When the strike price of a call is above the current market price of the associated stock, the call is “out of the money,” and when the strike price of a call is below the current market price of the associated stock, the call is “in the money.” Note that not all options are available at all prices: certain out-of-the-money options might not be able to be bought or sold.

The other common option is the PUT. Puts are almost the mirror-image of calls. Owning a put gives you the right (but not the obligation) to sell a stock at the strike price any time before the option expires. If you have written a put (you are short a put), you have the obligation to buy shares at the strike price any time before the expiration date if you get get assigned. A put is “in the money” when the strike price is above the current market price of the stock, and “out of the money” when the strike price is below the current market price. Then there are covered puts, which means you are short the stock at the same time as you write the put; also see the FAQ article on covered puts. Covered puts are a simple means of locking in profits on the covered security, although there are also some tax implications for this hedging move. Check with a qualified expert.

How do people trade these things? Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, they buy back the option (if they originally wrote a put) or sell the option (if the originally bought a call). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7 and, hopefully, sell it tommorow for $8, rather than actually calling the option (giving you the right to buy stock), buying the underlying stock, then turning around and selling the stock again. Paying commissions on those two stock trades gets expensive.

Although options offically expire on the Saturday immediately following the third Friday of the expiration month, for most mortals, that means the option expires the third Friday, since your friendly neighborhood broker or internet trading company won’t talk to you on Saturday. The broker-broker settlements are done effective Saturday. Another way to look at the one day difference is this: unlike shares of stock which have a 3-day settlement interval, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by Friday. While most trades consider only weekdays as business days, the Saturday following the third Friday is a business day for expiring options.

The expiration of options contributes to the once-per-quarter “triple-witching day,” the day on which three derivative instruments all expire on the same day. Stock index futures, stock index options and options on individual stocks all expire on this day, and because of this, trading volume is usually especially high on the stock exchanges that day. In 1987, the expiration of key index contracts was changed from the close of trading on that day to the open of trading on that day, which helped reduce the volatility of the markets somewhat by giving specialists more time to match orders.

You will frequently hear about both volume and open interest in reference to options (really any derivative contract). Volume is quite simply the number of contracts traded on a given day. The open interest is slightly more complicated. The open interest figure for a given option is the number of contracts outstanding at a given time. The open interest increases (you might say that an open interest is created) when trader A opens a new position by buying an option from trader B who did not previously hold a position in that option (B wrote the option, or in the lingo, was “short” the option). When trader A closes out the position by selling the option, the open interest either remain the same or go down. If A sells to someone who did not have a position before, or was already long, the open interest does not change. If A sells to someone who had a short position, the open interest decreases by one.

For anyone who is curious, the financial theoreticians have defined the following relationship for the price of puts and calls. The Put-Call parity theorem says:
P = C - S + E + D
where
P = price of put
C = price of call
S = stock price
E = present value of exercise price
D = present value of dividends
The ordinary investor will occasionally see a violation of put-call parity. This is not an instant buying opportunity, it’s a reason to check your quotes for timeliness, because at least one of them is out of date.

Many investors are up to date on the ins and outs of trading stocks daily. However, a less common vehicle of investing on leverage is trading options.  Here are some of the basic terms of option trading that will make you look like an expert at that next mixer party or sophisticated dinner gathering.  First, what is an ‘option’?  Options basically give the owner a contract to the rights (not the obligation) to buy or sell an asset at a given price and time.  The ’strike price’ is that specific price at which the owner can either buy or sell the option at.  The next two terms, ‘call’ and ‘put’ are dependent on whether you are trying to sell (think the price will go up) or buy (think the price will go down) the certain asset.  ‘Calls’ give the owner the right to buy the asset at a certain price and ‘Puts’ give the owner the right to sell the asset at a certain price.  If the owner decides to sell/buy, it is often referred to as ‘exercising’ the option.

A mutual fund is pool of money from various investors that is actively managed in the ultimate goal of creating wealth and benefiting shareholders.  While many people associate mutual funds with stock, in actuality, mutual funds can consist of stocks, bonds or even cash.  So what are the benefits of mutual funds?  Why wouldn’t I as an individual investor just go out and buy the stock or bond on my own?
First, the average individual investor does not have the purchasing power to mimic mutual funds.  Most mutual funds consist of tens to hundreds of stock or bond positions.  It would be extremely difficult (and cost inefficient) for a single person to attempt to buy positions in that quantity.  Also, buying pooling together money collectively, this allows the group of investors to be able to afford an asset manager.  The asset manager is in charge of controlling the mutual fund and making decisions in the best interest of the shareholders.
The second advantage of mutual funds is the diversification that it offers investors.  The term diversification is thrown around a lot in the investment world and it is an important concept.  There is an inherent risk associated with each specific position.  However, by spreading the risk across a hundred positions, you are drastically mitigating your risk.  Even if one company were to go bankrupt, you would still have ninety nine other positions holding ninety nine percent of the funds value to offset and minimize any losses.
Mutual fund asset managers are professional investors whose sole responsibility is to make the fund the most profitable it can be under its guidelines.  The average investor does not have the time, training or experience to make the daily decisions that asset managers encounter.  Traditionally, asset managers are proven performers within their company and have shown a track record of success.
Another advantage of mutual funds is the liquidity that they possess.  While most stocks trade while the market is open, mutual funds usually trade once a day.  However, for those that need to sell their positions and cash out, this can be done fairly quickly compared to Certificates of Deposit (CDs) certain bonds (municipal/government).  Mutual funds can be traded once a day at their daily Net Asset Value (NAV) and are lauded by many for the liquidity that they encompass.
Mutual funds are one of many different investment vehicles.  However, mutual funds are the proven choice for many investors because of its ability to mitigate risk, its professional guidance and its liquidity.  When properly researched and understood, mutual funds can be a great asset to any investor’s portfolio.

If you buy a personal finance book at Barnes and Noble or enroll in a Personal Finance and Investments course at the local college, one key concept that continually arises is “Pay yourself first!”. What this means is a predetermined portion of your disposable income should be going to yourself before anyone else gets paid. Once you establish an investment or savings vehicle (Roth IRA/CD/Stocks/Savings), make sure the first payment that gets made (after Income tax etc) is into your own accounts. This ensures that you are developing strong finance habits. Since you are more likely to default on payments to yourself, this ensures that both you as well as your bill collectors get paid.

Exchange Traded Funds (ETF) are a new rising investment vehicle in a market littered with stocks, mutual funds, index funds and bonds.   While there are many wild misconceptions of ETFs out there, a little knowledge on the strengths and weaknesses of ETFs will behoove all investors out there. Simply put, ETFs are a collection of stocks or bonds, much like a mutual fund.  This collection can be made of companies within a certain industry, size or even market.  For each mutual fund, there is most likely an ETF that very closely resembles the securities within the mutual fund.  However, there are a few key differences between ETFs and mutual fund.  It is difficult to say that in all situations, one investment vehicle overbearingly trumps the other.  But given an investors specific circumstance, we can pinpoint what type of investment will be most beneficial.
One of the key differences between ETFs and mutual funds is an ETFs ability to trade in and out throughout the day similarly to individual stocks.  Mutual funds on the other hand, do not offer the same flexibility when it comes to trading.  This allows ETF traders the ability to manipulate a tangent investment all throughout the trading day.
Another difference between ETFs and mutual funds lies with the expense ratio.  An expense ratio is basically the percentage of costs incurred for annual expenses.  ETFs generally boast a considerably lower expense ratio when compared to mutual funds.  While the difference between an ETFs expense ratio of 0.1 and a mutual funds expense ratio of 1.5 may not seem significant on paper, it is a considerable amount when compounded over a lifetime of investing.
There are different costs that are incurred to buy into ETFs and mutual funds.  Since ETFs trade like stocks, they incur costs similarly.  They are purchased through a brokerage (Ameritrade, Vanguard, eTrade etc) and therefore are charged brokerage fees for each transaction.  This generally ranges from four to twelve dollars.  On the other hand, mutual funds are charged through various loads.  Loads can either be charged in the form of a front load or back-end load.   Front loads are when a percentage of the initial investment funds are taken out while back-end loads are when a percentage of the investment is taken when selling the mutual fund.  There are also mutual funds that offer no loads.  Regardless, all of these ETFs and mutual funds still charge an expense ratio as previously discussed.  For someone who frequently trades in and out of investments on a daily basis, ETF brokerage fees may start to get pricier than a no-load mutual fund would.
The last difference between ETFs and mutual funds is the potential tax implications.  Mutual funds are actively managed funds that generally have a higher turnover ratio than ETFs.  Therefore, many mutual fund owners get stuck with taxable capital gain distributions.  ETFs have an advantage because it has the flexibility to distribute securities to shareholder and in turn avoiding shareholders from having to realize capital gains.
By learning what an ETF is and how it compares to other investment opportunities within the market, investors have another tool in their tool belt to utilize when beneficial.  ETFs can be a very valuable addition to one’s portfolio and ultimate quest to make money.

Few people realize the importance of Asset Allocation when it comes to one’s investment portfolio. And possibly, for the day trading professional investor who trades millions of dollars every day, this might not be such an important concept. However, for the everyday American working class, each day at the office is all in support of saving up for a new car, college tuition, that dream house, or ultimately retirement. Asset allocation defines how much of one’s portfolio should consist of different investment vehicles based on personal goals: risk aversion and time until investment money is needed. Time acts as a natural risk reducer because slight fluctuations in the market can be disregarded. The investor must look at his or her own personal goals and decide how much risk they would like to take. From there, they can allocate their assets among their various investment vehicles: stocks, bonds, mutual funds, cash, real estate. So why is it so important to follow asset allocation principles? First, it helps you analyze your individual goals and to plan for your future. Everyones situation is different and no one has your interests in mind better than you are. Second, by diversifying your assets, you are minimizing your risks because fluctuations in various markets go in cycles. Therefore, while your stocks may be having a bearish year, your bonds will pick up the slack and assuage the losses from stocks. You should always adjust your asset allocation every year or two as certain accounts may have grown at different percentages than other funds. If you are interested in reading more on asset allocation and looking through some suggested portfolios, read “A Random Walk down Wall Street” by Burton Malkiel.

A great general rule to govern compound interest rates is the rule of 72. Basically it answers the question, “How long will it take for me to double my money?”. Conversely, it can also answer “How much annual returns must I gain in a given time if I want to double my money?”. To best explain this concept, let’s look to an example. Let’s say I invest in a certain stock (AAPL) and I expect annual gains to average 10% in the next twenty years. I then divide 72/10 and get 7.2. This means it’ll take me approximately 7.2 years to double my money when it’s growing at a rate of 10%.