After you have decided whether you are hedging or speculating with your options purchase (please see Lesson #1 for further details on this topic), you will then need to determine which specific options fit your needs. When looking up an options quote -- more commonly referred to as an options chain -- you will notice that there are a barrage of choices available to you. Simply knowing that you wish to hedge or speculate is not sufficient. You will need to determine if your desired strategy requires you to trade a put or a call option, how long you wish the expiration date to be, and what strike price you would like to trade. Before trading options, it is important to familiarize yourself with the factors that impact options prices so you choose the best one to meet your needs.

Factors that determine option pricing:
Option pricing is determined using a complex differential equation formulated by Myron Scholes and Fischer Black in 1973. In 1997 these two professors were awarded the Nobel Prize for their efforts. The Black-Scholes formula in detail and its explanation are beyond the scope of this article. Fortunately, however, it is not necessary to understand the model’s intricacies in order to make proper option trades.

The five basic components of option pricing include the following:

• Underlying Asset Price -- The price of the underlying stock or index the option is written on.
• Asset Volatility -- Amount of uncertainty associated with the asset’s expected return. In general, the higher the volatility the more expensive the option will be. For example, if an asset’s value is $100 today, and next month the price is estimated to be either $125 or $75, then the amount of uncertainty here is very high. Because of this, the option price will be high as well (after all, the more volatile the security, the greater chance that it will deliver large returns for the option holder). This uncertainty of return is one of the main drivers of option prices.
• Time to Expiration -- The amount of time left before the option expires. The price of an option decreases as it approaches its expiration date. Why is this the case? Well, as the expiration date approaches, the chances of the option gaining in value become lower and lower because the underlying security has less time in which to make a major up or down move.
• Risk-free rate -- For a variety of reasons that are beyond the scope of this article, the rate of return that may be earned without bearing any risk also comes into play when pricing options. Normally this is assumed to be the rate of interest earned by U.S. Treasury Bills.
• Option Strike Price -- This is the price at which the option can be exercised.

All of these factors play an important role in determining every option’s price. The only two factors that an investor has any control over, however, are time to expiration and the strike price (this is assuming, of course, that you've already chosen the security on which you're going to trade the option). Because of this, investors should concentrate their efforts on choosing the appropriate strike and expiration that best suits their needs. The following are rules of thumb for what hedgers and speculators should consider:

Hedging:

• Use Puts -- Investors are generally long the market. In other words, they generally own stocks but do not short them. To offset the risk of owning a large stock portfolio (or large individual stock position), you can buy put options that will increase as your portfolio (or individual stock) declines. By purchasing put options, investors can limit the amount of money they will lose if the market plummets.
• Longer Expiration -- Investors normally hold stocks for longer periods than speculators and therefore buy insurance for longer periods of time. They tend to purchase options with longer expiration dates.
• Out-of-the-Money Options -- Most investors are concerned with buying insurance to protect their capital from falling below a certain amount. This amount is generally somewhere below where the current stock price is.

Speculating:

• Use Calls -- Speculators usually purchase options on a particular stock rather than the actual stock itself. Why? Well, if the speculator is correct in predicting the direction of the stock, then he or she will make far more money by holding options thanks to the leverage that options provide. An investor can control a large amount of stock with a very small amount of money by utilizing options.
• Short Expiration -- Speculators usually expect a move in a stock in a short amount of time. Therefore, they often buy less expensive options with short expiration dates.
• In-the-Money Options -- Many different trading strategies existing, but in general, speculators often buy in-the-money options so they can capture profits more quickly from rising stock prices.

There are a number of risk/reward characteristics of in- or out-of-the-money (ITM/OTM) options that all investors should consider. An ITM option will cost significantly more money to purchase, but the probability that it will at least have some value at expiration will be far greater. An OTM option will cost less money up front, but the probability of it expiring worthless will be much higher. The reason investors purchase OTM options is due to the fact that a correct bet can lead to very significant gains of many times your purchase price. Meanwhile, the potential downside from such a purchase is usually a total loss.

Sometimes it can help to visualize what happens when a trade is made. The diagram below illustrates an example of what a sample option will be worth, as well as the gain/loss to the investor who made it. Once again, we will use shares of IBM as an example.

Let's suppose it is January and the stock is currently trading at exactly $100 per share. An investor who owned 100 shares of IBM and wanted to hedge against a loss until the 3rd Friday in February would likely purchase a February 100 put option contract on IBM. This means that the buyer of the put would essentially be insured against a loss below $100, less the cost of the option. In this example, we will assume the option cost is $3. This means that no matter what happens, the investor’s position in IBM will not be worth less than $97 ($100 - $3 option cost) by expiration in February.

In this example, we can see that the put option increases in value as the stock price declines below $100. If IBM is trading above $100 per share on the third Friday in February (the expiration date in this example), then the option will expire worthless and the investor will lose his or her entire option premium. But since the investor in this example actually owns IBM shares, this will likely be of little consequence.

However, if IBM tumbles to $90 at expiration, then the investor will have lost $10 on the stock. Thankfully though, this investor decided to hedge his/her position by purchasing a put option. And since put options rise in price as the underlying security falls, this particular option will have soared in value. It will now be worth $10. Subtract the cost of the option, $3, and we can see that the investor's net position will be worth exactly $97. It's important to note that the value of the investor's position will remain $97 even if the price of IBM drops to zero! So, as you can see, purchasing put options against stocks that you own in your portfolio will require you to pay option premiums, but it will also protect you from suffering catastrophic losses if the market nosedives.

This strategy is especially useful if you're looking to lock in gains after a stock has experienced a significant run-up. You may still believe the stock will appreciate more, but you might also be unwilling to let it decline below a certain point.

Sticking to our same example above, consider what would happen if IBM had just skyrocketed to $100 in a brief amount of time (before the investor purchases the put option). In this case, the investor might be tempted to exit the position to lock in his/her gains. Although the investor could sell the stock immediately at $100, he/she could also use the option strategy above (purchasing a FEB 100 put option) to limit any potential future losses to just $97. If the stock were to subsequently appreciate to $120, then the investor who sold his/her shares would not participate in the additional $20 gain. However, if the investor utilized the put option purchase, then he/she would have enjoyed the safety of locking in a minimum stock price (in this case $97), while still being able to participate in further gains. So, if IBM soared further, jumping from $100 to $120, then the investor's net position would still be worth $117 ($120 for the stock minus $3 to purchase the option). That's a small sacrifice to make for securing a gain!

Please click below to read Lesson #3 of this options series. In it, we'll discuss various portfolio hedging techniques as well as writing options.

-- Jeff Bishop
Staff Writer
StreetAuthority.com

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