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Take advantage of sophisticated options tools, education, and specialized support-all at a great price.

Options are powerful because they can enhance an individual's portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor's goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
How Options Work

An option is the potential to participate in a future price change. So, if you own a call, you can participate in the uptrend of a stock without owning the stock. You have the option to participate.

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.

Let's look at an example of a call option on International Business Machines Corp. (IBM) with a strike price of $200 expiring in three months. IBM is currently trading at $175. Remember, owning the call option gives you the right, but not the obligation, to purchase 100 shares of IBM at $200 at any point in the next three months. If the price of IBM rises above $200 at any point within three months, then the call option will become in-the-money.

The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminishes as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn't move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month.

This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn't move.

Types of Options

American and European Options

Now that we've talked about the differences between calls and puts, let's explore some other differences of categorizing options contracts. American options can be exercised at any time between the date of purchase and the expiration date. The example of Cory's Tequila Co. shows the use of an American option. Most exchange-traded options are American. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.

Options Expiration & Liquidity

Options can also be categorized by their duration. Short-term options are those that expire generally within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities, or LEAPs. LEAPs are identical to regular options, they just have longer durations. Although they aren't available on all stocks, LEAPs are available on most widely held issues. You should know that LEAPs can be less liquid than shorter term options, so they are not ideal for short-term trading.

Options can also be distinguished by when their expiration date falls. Traditionally, listed options have expirations on the third Friday of the month. However due to increased demand, sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.

Options Exchanges

Options traded on exchanges are called listed options. In the U.S., there are a number of exchanges, both physical and electronic, where options are traded. For U.S. stocks, there are 15 options exchanges on the last count. Options can also be traded directly between counterparties with the use of an exchange or an ISDA agreement; these are known as over-the-counter (OTC) options. Often, financial institutions will use OTC options to tailor specific outcome events that are not available among listed options.

Market makers exist in order to provide liquidity to options markets. They are required to 'make' a two-sided market in an option if asked to quote. Market makers, using theoretical pricing models, can take advantage of arbitrage by exploiting theoretical mis-pricings between the options' perceived value and its market price.

The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject of options can be difficult to understand at first, these plain vanilla options are as easy as it gets.

Because options are so versatile, there are many other types and variations of options. When ordinary listed or OTC options won't do, there are exotic options. They are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with "optionality" embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options and Bermudan options. Again, exotic options are typically for professional derivatives traders.

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