Options

TM

Options U
Essentials
Learn the fundamentals of options investing — and make your first trade.
In this course, you’ll see what options can do, the lingo, the parts of a trade,
buying vs. selling options, and more

Lesson 1: What Are Options?

Start with the basics of how these investments really work

Lesson 2: Getting Permission

Before you can trade options, you’ll need to fill out forms

Lesson 3: Nuts & Bolts: Puts & Calls

These two elements are the key to everything you can do with options

Lesson 4: Buying Options

Boost your returns while limiting your risk

Lesson 5: Writing Options

Get paid while you wait for the market to work its magic

Lesson 6: Cracking the Code

Decipher the 21 digits of an options symbol

Lesson 7: Pricing
Go in and out of the money to see what an option is really worth

Lesson 8: Exercise and Assignment

See what happens to your trade when an option reaches its end

options.fool.com Options U: Essentials Motley Fool Options 1

Lesson 1
What Are Options?
A simple way to understand options as an investment tool
An option is a contract giving you Puts
the right to buy or sell a stock at a set
price by a set date. You’re making a A put option is a contract that
prediction on how the stock’s price represents the right to sell a stock at a
will move in the future — and you set price by a set date.
profit if the stock moves in your favor. in
When You
Exchange
Two Options, You Receive
For
Many Possibilities Buy Right to Premium
There are only two types of options, Puts sell shares payment
each of which you can buy or sell: Obligation
Sell Premium
to buy
Puts payment
Calls shares

A call option is a contract that ◉◉ If you think a stock will

represents the right to buy a stock at a decrease, you can buy puts,
set price by a set date. giving you the right to sell
shares at the set price even if
in the actual price is lower
When You
Exchange
You Receive ◉◉ If you think a stock will
For
increase, you can sell (or
Buy Right to Premium
Calls buy shares payment “write”) puts, giving you an
initial payment but also the
Obligation
Sell Premium
to sell
obligation to buy shares if the
Calls payment stock falls to the set price —
shares
which you’re predicting won’t
◉◉ If you think a stock will happen
increase, you can buy calls,
giving you the right to buy These strategies — on their own and
shares at the set price even if combined into more complex trades
the actual price is higher — will be your tools for successfully
making options part of your portfolio.
◉◉ If you think a stock will decline, As you continue through Options U,
you can sell (or “write”) calls, you’ll learn the how to put it all into
giving you an initial payment action.
but also the obligation to sell
your shares if the stock rises
to the set price — which you’re
predicting won’t happen

2 Motley Fool Options Options U: Essentials options.fool.com

Lesson 2
Getting Permission
Before you can trade options, you’ll need to fill out forms
Before you make your first options
trade, you’ll need to have a brokerage
account and get approved for options
investing. This can take time, so it’s
worth starting the process before you
want to start trading.
Applying for options trading
permission with your broker involves
filling out a form that they’ll give
you when you ask. Simply say, “I’d
like to apply for full options trading
permission, please.” You’ll need to
answer questions about your investing
experience, your assets, and a bit more.
It can take a week or longer to get
approved. If you plan to follow along
with our options trades, you’ll want to
apply for full permission right away.
With most brokers, you can buy
options even if you have very little
money, say $5,000 or $10,000.
The advantage of buying an
option contract or two is that you
can “control” many shares of the
underlying stock for, typically, just
a few hundred dollars. If the stock
rises, you’ll earn strong higher returns
on your money. However, to make
options worthwhile after spreads and
commissions, we suggest have at least
$10,000 in your account.
options.fool.com Options U: Essentials
To sell — or write — options, you
should have a higher account balance.
Typically, a brokerage firm may
require about $25,000 before you can
sell put options, less if you wish to sell
covered calls (there, you only need to
own the underlying stock).
If you’re not ready or able to sell
puts yet, that’s perfectly fine. Writing
covered calls is similar to writing puts,
and can work in much the same way.
Meanwhile, buying options always
requires less capital, and as your
account balance grows and you gain
more experience, you can start to use
more involved options strategies.
When writing any options, the
brokerage terminology used to start
the position is “sell to open.” To later
close the position, you would use
“buy to close.” Writing options — put-
writing, specifically — requires ample
buying power in your account. Be
sure to review your cash and margin
buying power before writing a put
option. Meanwhile, buying options
is not unlike buying stocks. You can
buy options with cash or partly on
margin, but margin is certainly not
recommended.
Step by Step
1 Choose a broker: If you
already have a brokerage
account, you should be able
to continue trading there. If
you’re looking for a broker,
we recommend using a
discount broker so trading
costs don’t eat into your
gains. You can compare
features, fees, and reviews
on our website.
2 Get permission: Trading
options requires special
permission from your broker.
You’ll have to answer a
few questions about your
trading experience, and we
recommend applying for the
highest or second-highest
level of options trading
permission (Level 2 to Level
4; it varies by broker). Try
to get options-writing
permission. If you receive
Level 1 to start, don’t fret.
We’ll have plenty of trades
for you, and as you gain
experience, you can reapply
for higher permission.
3 Set aside cash: You’ll need
some money to buy options
— ideally, you’ll have $10,000
or more in your account to
start.
Motley Fool Options 3
Lesson 3
Nuts & Bolts: Puts & Calls
These two elements are the key to everything you can do with options
There are only two types of options:
calls and puts. A call appreciates when
the underlying stock rises, so you
buy a call if you are bullish on that
company. A put appreciates when a
stock declines. You buy a put if you
believe a stock will fall or to hedge
a stock that you already own. One
way to remember this is: “call up; put
down” (as in, call something up, or put
something down).
Let’s walk through some of the most
common options trades: buying calls,
buying puts, selling covered calls, and
selling puts.
Strategy Why Use It
When you believe a stock
will rise significantly
Buy
and you want to leverage
Calls
your returns or minimize
capital at risk
To short a position, or to
Buy
hedge or protect a current
Puts
long holding
To earn income on shares
Sell
you already own while
Covered
waiting for your desired
Calls
sell price
To get paid while waiting
for a lower share price
Sell
(your desired buy price)
Puts
on a stock you would be
happy to buy
Buying Calls
Investors often buy call options rather
than buying a stock outright to obtain
leverage and potentially increase
returns several-fold. Call options work
as “controlled” leverage, enhancing
4 Motley Fool Options Options U: Essentials options.fool.com
your possible returns while limiting $20, so your options expire worthless
your potential losses to only what — though hopefully you sold them at
you invest (which is usually a much some point along the way to recoup
smaller amount than a stock purchase part of your investment.
would be). Because each option
At Motley Fool Options, we typically
contract represents 100 shares of stock,
buy longer-term call options on
an investor can control — and benefit
well-valued stocks that we believe
from — many shares of stock without
will reward you handsomely over the
putting a lot of capital at risk. When
coming months or years. It’s a way to
you make the right, er, call, you’ll
take more meaningful positions in
enjoy higher returns than you would
stocks we believe in, without risking
have if you had used that money to
mounds of capital. This is useful if
buy the actual shares.
you’re lacking capital or just don’t feel
Let’s look at an example. Imagine like risking it all in a stock.
that a stock that you know well has As with any investment, you should
been hit hard and now trades at $27 only invest what you can afford to lose,
per share. You believe the shares will since a stock can easily work against
rebound in the coming months or year. you in a set amount of time and
The market offers $30 call options on
make your call worthless. Where real
the stock that expire in 18 months for
opportunity can be lost is when your
$1.50 per share. Therefore, 10 contracts,
timing is wrong. Your options might
representing 1,000 shares of the stock,
expire before the stock rebounds,
will cost you $1,500 plus commissions.
causing you to lose your option money
This option contract gives you, its
and miss the stock’s eventual rebound.
owner, the right to buy 1,000 shares
Thus, we aim to buy longer-term calls
of the stock at $30 any time before
in positions in which we have high
expiration.
confidence and that have short-term
If your stock starts to rise again, your catalysts.
options will increase in value, too.
Suppose the stock recovers all the Buying Puts
way to $32 after a few months. Your Next up, the antithesis to call options:
option’s value would likely at least puts.
double to $3 or higher per contract.
You’ve made 100% in a few months. We buy put options when we believe
that the underlying stock will decline
If you had simply bought the stock,
you’d only be up 18.5%. in value. Buying puts is an excellent
tool for betting against highly priced
Of course, there is a flip side. Suppose or troubled stocks, or even entire
your stock continues its decline to the sectors! With put buying, your risk
abyss. Even 18 months later, it’s below is again limited to the amount that
you invest, in stark comparison to
traditional short selling, where your
potential losses are unlimited. Ouch!
Aside from betting against a position
with puts, we may also buy puts to
protect an important position in our
portfolio, one that we don’t want to
sell yet for any number of reasons.
When a stock being protected — or
hedged — in this way declines for a
while, the puts will increase in value,
smoothing out our returns.
We will recommend buying puts
on stocks that we believe are due to
decline over the coming months or
even years. We may also use puts
to hedge long positions, or to short
sectors and indexes. We’ll almost
always recommend buying puts rather
than shorting outright, to limit your
risk.
Selling Covered Calls
Now our overview moves from buying
options to selling them.
Any qualified investor can “sell to
open” an option contract. When you
do so, you don’t pay the premium;
instead, as the contract writer, you get
paid. All cash generated from your
option selling is paid immediately and
is yours to keep.
Do we have your attention? We
thought so!
The call options that we write (or
sell) are almost always covered calls.
“Covered” simply means that we own
the underlying stock at the same time.
Writing covered calls is one of the
most conservative options strategies
available. In fact, most retirement
accounts allow you to write covered
calls. They’re generally used to
generate income on stock positions
while waiting for a higher share price
at which to sell the stock.
options.fool.com Options U: Essentials
Here’s an example of a covered call.
Suppose you own 1,000 shares of a
stable, blue-chip stock. It’s trading at
$56, but you think it is fairly valued
around $60 and you would be happy
to sell at that price. So you write $60
call options on the stock expiring a
few months ahead, and you get paid
up front to do so.
If the stock does not exceed $60 by
your option’s expiration, you keep your — lost potential if a stock price rises.
shares and you’ve made money on
the call options. You could then write sharply after hovering around your
more calls if you wanted to. If the
stock is above $60 by expiration and
you haven’t closed out your call option
contract, you’d sell your stock at $60
via the options. Your actual proceeds
on the sale would include the option
premium you were paid. So you sold
your shares at the price you wanted
to and received some extra cash for
doing so. That’s pretty sweet.
So, write covered calls when:
◉◉ You would sell a stock that
you own at a higher price,
and you’re not worried about
it declining too much in the
meantime. Write calls at your
desired sell price, collect the
dough, and then kick back and
wait. Rinse and repeat, month
after month, when you can.
◉◉ You believe a stock you own is
going to stagnate for a while,
but you don’t want to sell it
right now. Write calls to make
the stagnation more profitable.
◉◉ You want to cushion a stock
that is in decline, but that
you’re not ready to sell yet.
Tread carefully here so you
don’t get sold out at too low a
price.
When you write covered calls,
you must be prepared to give up
your shares at the strike price.
Approximately 80% to 90% of options
are not exercised until expiration, but
they can be exercised early, so the call
writer has to be prepared to deliver
the shares at any moment.
That means that if the $56 stock in the
example above suddenly soars to $70,
you’d still have to sell at $60. This is
the biggest downside to covered calls
The other risk is that a stock may fall
desired sell price for a while, forcing
you to wait longer for your sell price.
Even though covered calls are low risk,
we’ll still use them only on stocks we
know well. We may even set up some
covered call-only positions — buying
a stock just to write calls on it.
Selling Puts
Note: to sell puts, you must have a
margin account. You won’t actually
need to use margin — which entails
high risk — but you must be margin-
approved, have ample buying power
(cash, in our margin-free strategy),
and have full options permission from
your broker.
Selling puts — also referred to as
selling naked puts — is a favorite
strategy of mine to seed a portfolio.
There may be plenty of stocks that
we’d like to buy at the start, but we’d
prefer to snag them at lower prices.
Put options are an excellent way to
potentially buy a stock at your desired,
lower share price and get paid an
option premium while waiting for that
price, whether it arrives or not.
Let’s turn to an example: A top-
rated stock we found on CAPS and
researched thoroughly is trading at
$39, but our analysis suggests that we
shouldn’t buy it above $35. The $35
Motley Fool Options 5
put options expiring four months out
are paying $3 per share. We “sell to
open” the put contracts and get paid
$3 per share to make the trade, giving
us a potential net purchase price of
$32 before commissions. A few things
could happen here.
Scenario 1: The stock could stay
above our $35 strike price; the
options we sold would expire. We
didn’t get to buy the stock at the
price we wanted, but at least we made
money on the options we sold.
Scenario 2: The stock could
fall below $35 by expiration. In
this situation, our broker would
automatically buy the stock for our
account, giving us a start price of $32
before commissions — even lower
than our $35 desired buy price!
Scenario 3: The stock may tank
to $29 soon after we sell the puts,
but then climb back above $35 by
expiration. In this case, we most likely
would not have had the shares sold to
us during this brief decline because
about 80% of options are exercised only
at expiration, not before. So we won’t
own the shares, and we’ll have missed
our buy price and the stock’s rebound
— but we did get paid the premium, at
least, and can try again.
Scenario 4: The company’s CEO
flees to Bermuda and the stock
is only at $16 by our option’s
expiration. We didn’t have the heart
to close our losing option position,
and we still have hope, so we wait and
the shares are “put” to our account at
$35 (minus our option premium) upon
expiration. This is the worst-case
scenario — we’re down 50% to start.
But we own the stock now and can
hope it rebounds. Of course, assuming
that we would have bought the stock
outright when it hit our $35 buy price,
as we had considered, we would be
down even more than we would be
with this strategy.
We will most often recommend selling
puts when a stock we follow closely and
want to own (or own more of) is, alas,
above our desired buy price. We’ll sell
puts on it at lower strike prices, prices
that we believe are great levels at which
to buy. Either we’ll eventually get to
buy the stock at our desired price via
the puts, or we’ll keep writing puts if
the situation merits it. We may also
sell puts when a stock we already hold
a partial position in is above the price
where we’d like to buy more. We’ll write
puts as we wait to average in at lower
prices. This is a great tool for allocation
and averaging into a position.
Writing puts on stocks you know well
and want to own at lower prices can
be an excellent tool for income and
for securing lower buy prices, but you
must be prepared to buy the stock
should it fall below your strike price. At
all times, you must maintain the cash
or margin (for us it’s always cash and
we recommend you follow that rule,
too) to buy shares if they are put to you.
It’s important that you only write puts
on stocks that you understand well
and will be happy and ready to buy at
the prices you’re targeting. The risks
of writing puts include the fact that
the stock could soar away without you.
In many cases, it’s better to just buy a
great stock once you’ve found it. The
other risk, of course, is that a stock
falls sharply and you’re stuck owning
it. The biggest risk with selling puts, as
with all options, is when investors rely
on margin instead of cash. That can
quickly wipe out a portfolio.

Call Option Put Option

Option Buyer ◉◉ Believes the underlying stock will rise
◉◉ Has the right to buy a stock at a set
price
◉◉ Calls gain value as the stock rises (“call
up”)
Option Seller ◉◉ Has the obligation to sell a stock at a set
(Writer) price
◉◉ Must hold the stock in the account to be
a “covered” position
◉◉ If the stock rises, is ready to sell the
existing shares at the strike price
◉◉ Keeps the premium received for writing
the option
◉◉ Believes the underlying stock will fall
◉◉ Has the right to sell a stock at a set price
◉◉ Puts gain value as the stock falls (“put
down”)
◉◉ Has the obligation to buy a stock at a set
price
◉◉ Must have the buying power at the ready
(preferably in cash) in case the stock
declines
◉◉ If the stock falls, is ready to buy it at the
strike price
◉◉ Keeps the premium received for writing
the option

6 Motley Fool Options Options U: Essentials options.fool.com

Lesson 4
Buying Options
Boost your returns while limiting your risk
At first, most investors are compelled
to buy options rather than write them.
They’re lured by the prospect of large
percentage returns and the small
investment needed to earn them. But
this is an unfortunate introduction to
options because the odds are stacked
against the option buyer, and it’s
easy to lose your whole investment
on a trade. And once that happens,
many new investors abandon options
entirely, forsaking them as too risky
without ever learning about their
benefits.
That’s partly why we started with a
focus on writing options: You have
more chances to ultimately be right
thanks to the strategic involvement of
the underlying stock, and the option
premium and expiration work in your
favor rather than being hurdles to
overcome.
So, now that you have a better
understanding of writing options, you
can consider the pure leverage that
comes with buying them — but use
this leverage in moderation. What’s
more, in many cases, you’ll be able
options.fool.com Options U: Essentials
to write options to offset the cost of
buying them. Smart.
Buying Pros and Cons
There are many advantages to buying
options:
◉◉ Your potential profits are
unlimited, while your losses
are always limited to what you
invest.
◉◉ Buying options usually requires
little capital; many cost only a
dollar or two, so you can risk a
total of just $100 to $200.
◉◉ You control 100 shares of stock
with every contract, so you
have tremendous leverage.
◉◉ Buying puts allows you to
protect stocks you own or
profit on any stock if it declines
while limiting your risk (unlike
just shorting a stock).
◉◉ If a trade goes in your favor,
you can quickly earn 50%,
100%, or more.
But there are numerous drawbacks to
buying options, too:
◉◉ If the stock moves against you,
it’s easy for your investment to
lose most — and ultimately, all
— of its value.
◉◉ You’re buying a wasting asset.
The “time value” of any option
decays over time, and rapidly
as expiration approaches.
◉◉ You pay the premium when
you buy an option, so you’re
starting in a hole.
◉◉ In many cases, when you
buy an option, you have little
recourse if the trade works
against you.
Buying options opens a new world to
investors, one fraught with excitement
and big reward — but also with high
risk if used in an undisciplined manner.
When you buy, the clock is ticking, and
you need to be right before expiration.
However, there are many ways to give
yourself extra advantages, and we’ll be
using all of them.
Motley Fool Options 7
Lesson 5
Writing Options
Get paid while you wait for the market to work its magic
Writing options is one of our
favorite options strategies, and we’ll
recommend it often. The combination
of writing options and owning
superior stocks provides the best of
both investing worlds: near-term
option income and long-term stock
profits.
The Wall Street Journal reports that
about 30% of all options expire
unexercised — and as option writers,
that’s usually what we want. This results
in consistent, repeatable profits. But
over the years, I’ve found that careful
option writers can do much better
than 30%, generating income on these
strategies a vast majority of the time.
There are plenty of other benefits to
being an option writer:
◉◉ You collect cash right away.
◉◉ You have time on your side:
Options steadily lose time
value as they near expiration.
◉◉ You choose your desired buy
price (writing puts) or sell price
(writing covered calls) on the
underlying stock, so there are
no surprises if the option is
exercised.
◉◉ You usually have plenty of
leeway with your strategy —
the stock can move a lot, and
you still earn a profit.
◉◉ It’s a disciplined approach: You
can earn better, safer returns
on stocks you know well, build
your portfolio, hedge it, or sell
positions higher.
8 Motley Fool Options Options U: Essentials options.fool.com
◉◉ You almost always have
recourse: If you write puts
and the stock falls, you end
up owning the stock and can
wait for a rebound. If you write
covered calls and the stock
soars, at least your position
still results in a profit, even if
you miss additional upside.
◉◉ These strategies are easy to
repeat. You can profit the same
way again and again and ...
Don’t Overwrite Yourself
The main drawback to writing options
is that missed upside. The maximum
profit you can earn (from the option
itself) is what you’re paid at the start,
so you need to write options regularly
if you’re going to grow your portfolio
meaningfully. These small, repeatable
gains can add up — especially when
combined with a portfolio of strong
stocks. But it can be tempting to
overstretch yourself to land larger
gains. However, it’s important to stay
disciplined and only write options
when you can easily fulfill the
potential obligation.
It’s true, every option you write is
really a potential obligation:
◉◉ For every put you write, you’re
agreeing to buy 100 shares
of the underlying stock if it
declines and stays below your
strike price by expiration.
◉◉ For every covered call you
write, you’re agreeing to sell
100 shares of the stock if it
7 Writing Lessons
1 The trade command,
whether writing a covered
call or a put, is usually “sell
to open,” “sell,” “write,” or
“short.”
2 You’re paid for writing the
option on day one. You keep
this money no matter what.
3 Until the option expires, you
have a potential obligation
to either buy stock (when
writing puts) or sell stock
(when writing covered calls).
4 Much like a short, the
option’s current value
shows in your account as a
negative number.
5 As the option falls in price,
you capture the gains
you were paid up-front
until the option expires
and disappears from your
account.
6 You can always “buy to
close” an option you wrote
before it expires, paying the
going market price — either
for a loss or gain depending
on that price.
7 Your obligation ends when
you buy to close early or
when the option expires.
goes and stays above the call’s
strike price. So, you need to
own the stock.
If you write many more puts than
your account can handle, a slide in the
stock could — just like heavy margin
use — wipe you out if your puts are
exercised and you need to purchase
buckets of shares. (This is why it’s
harder to get permission to write
options than to buy them.) Or, if you
write naked calls (in which you don’t
own the underlying stock), your losses
are potentially limitless.

But Buying Isn’t Bad

In contrast to the benefits enjoyed by
the option writer, option buyers:
◉◉ Pay money up front to make
the trade and have time
working against them from the
start.
◉◉ Need to see a meaningful,
timely move in the stock, and
in the right direction, to make
the trade profitable.
◉◉ Have no recourse if their
options expire out-of-the
money; the whole investment
is lost.
That’s not to say buying options
doesn’t have many advantages. You
can risk very little money and leverage
your investment to earn outsized gains
when you’re right. But you need to
be right — and right in time. When
we do step up to buy options, our
confidence level in the trade is high,
and we expect great things before
expiration.

options.fool.com Options U: Essentials Motley Fool Options 9

Lesson 6
Cracking the Code
Decipher the 21 digits of an options symbol
The first time you pull up a page of
options quotes the dizzying array of
symbols, strike prices, and expiration
months — all for just one company —
can be overwhelming. But fear not. It’s
really quite easy to decipher the 21-digit
codes.
See the table below for a quick look at
how to build the symbols, using the
following Interactive Data (NYSE: IDC)
February 2010 $25 put option as our
example.
If that isn’t quite clear as a bell, don’t
worry — we’ll continue to refer to our
trades by their month and strike price,
as in the “Interactive Data February
2010 $25 puts.” With most brokers,
all you’ll need to do is quote the
underlying stock, then click to get its
options. From there, choose the strike
and month you want, calls or puts,
and make the trade.
There are also three prices quoted.
“Last Price” is simply what it says it
is — the last traded price of the option. have the bid-ask spreads overwhelm us.
However, this last price may have been
at a very different price than what the
next transaction will occur at. Like
any security, the “bid” price is what
the counterparty is willing to buy
the security for, and the “ask” price
is what the counterparty is willing to
sell for. With options, there is often
substantially less liquidity in the
market. Consequently, you definitely
need to watch the bid-ask spread!
Stocks with a greater option volume
and more liquid trading generally have
a narrower spread. Those $20 August
2009 Cisco calls have a spread of 1.5%
between bid and ask. In comparison,
the stock currently has its bid and ask
only $0.07 apart, meaning the bid-ask
spread there is only 0.32%. And Cisco
has some pretty tight bid-ask spreads.
Options on smaller companies can
have positively murderous spreads —
6%, 8%, or even 10% or more. Thus, in
Motley Fool Options, we’ll generally use
strict price limit orders, so as not to
Further note that call prices decline,
and put prices rise, as the option’s
strike price increases. This is as it
should be. If Hewlett Packard (NYSE:
HPQ) trades at $42, which call option
would you anticipate as more valuable?
The one letting you buy shares at $40
(which you could immediately turn
around and sell in the market for a
$2 profit), or the one letting you buy
shares at $45 (which would cost you
more than $3 more than what you
would pay on the open market today)?
Invoking the old “bird-in-the-hand”
idiom, you’d happily pay more for the
one that comes with the built-in profit.
Finally, know that options are sold in
contracts for 100 shares. In buying
an Intel (Nasdaq: INTC) $20 strike
October 2009 put, you’re buying the
right to sell 100 shares of Intel for $20
before close of trading on the third
Friday in October 2009, and paying
about $160 (the current ask price of
$1.60 multiplied by 100 shares per
contract) for the privilege.

How to Build an Options Code

Ticker Expiration Call or Put Strike Price Dollars Strike Price Decimals
always 6 characters; add 2 digits each for “C” or “P” always 5 characters; always 3 characters;
spaces if necessary year, month, day precede with zeros if add zeros if necessary
necessary
IDC 10 02 19 P 00025 000

symbol for this option: IDC 100219P00025000

10 Motley Fool Options Options U: Essentials options.fool.com

Lesson 7
Options Pricing
Go in and out of the money to see what an option is really worth
Before you begin using option Intrinsic Value
strategies as part of your portfolio,
you need to know how to find and Intrinsic value is the If Stock Price If Stock Price If Stock Price
understand how they’re priced. Let’s difference between Option Is Less Than Is More Than Is Equal to
the stock price and Strike Price Strike Price Strike Price
say Cisco (Nasdaq: CSCO) is selling
for $22. You like the company. You the option’s strike Stock Price –
Call $0 $0
like the price. In fact, you really like price. IV cannot be Strike Price
the price. In addition to buying shares less than zero, since Strike Price –
the option holder Put $0 $0
outright, you decide to augment your Stock Price
potential gains by buying some call wouldn’t exercise
options. If you’re right, the price of a call with a strike price of $30 if the
the shares will rise and the value of same stock is trading in the market
the options will soar along with it. But at $25. (If you know people who
before you can use options to boost would, please email me their contact
those returns, you need to know how information privately — I’ll be happy
to find the right option trade at the to sell them as many shares as they
right price. want!) IV is calculated solely based on
how the underlying stock price moves
An option’s price is the sum of two in relation to the option strike price:
components: intrinsic value, or IV, and
time value, or TV. Time Value
Time value is simply the premium
that people are willing to pay for the
potential upside of the stock until
expiration. Options are “wasting assets”
— that is, as time passes and expiration
approaches, TV gets progressively
smaller until you’re out of time, and
TV equals zero. The corollary is that at
expiration, the option’s value is simply
IV. Prior to expiration, TV is always
positive, even though it may be very
small, such as when the stock price
is far above or far below the option’s
strike price.

options.fool.com Options U: Essentials Motley Fool Options 11

Putting It Together
Consider these General Electric (NYSE: GE) calls, for a stock currently trading at $13.30:
Call Strike Price Option Premium
$10 $3.45
$10 $3.60
$10 $3.80
$15 $0.21
$15 $0.61
$15 $0.99
There are three key observations from
this table:
1 Anytime the strike price is
greater than or equal to the
current stock price, IV is zero. In
such cases, the option value is
solely attributable to TV, and
the expectation (hope?) is that
the stock price will meander
back above the strike price by
expiration.
2 The less time remaining until
expiration, the lower the TV.
3 For options with a common
expiration date, TV is
maximized when the strike price
and the stock price are equal. As
the stock price moves in either
direction, TV falls.
12 Motley Fool Options Options U: Essentials options.fool.com
Expiration Date Intrinsic Value Time Value
September 2009 $3.30 $0.15
December 2009 $3.30 $0.30
March 2010 $3.30 $0.50
September 2009 $0 $0.21
December 2009 $0 $0.61
March 2010 $0 $0.99
We’re In the Money! If Starbucks (Nasdaq: SBUX) trades
for $17.70 in August, and you own $16
You’ll hear phrases like “in-the-money” October calls selling for $2.40, you
or “out-of-the-money” bandied about. wouldn’t bother to exercise early to
This is just a fancy way of denoting collect the $1.70 spread ($17.70–$16) —
whether an option has intrinsic value or you’d sell the calls on the open market
not. If IV is positive, the option is said for $2.40.
to be in-the-money. If IV is zero, it’s
termed out-of-the-money.
Expressing options as the sum of IV
and TV also leads to the conclusion
that early exercise of options generally
doesn’t make sense (though there are,
as always, exceptions to the rule). The
thinking goes like this:
◉◉ An option is worth IV + TV
◉◉ I can exercise it now and
receive IV, or
◉◉ I can sell the option and
receive IV + TV
◉◉ IV + TV is more than IV.
Therefore, selling an option
rather than exercising early is
the superior choice.
Lesson 8
Exercise and Assignment
See what happens to your trade when an option reaches its end
Exercising an option simply means
that the buyer of the call or put
invokes their right to buy or sell the
underlying stock at the strike price.
When the option buyer (or holder)
decides to exercise, the writer of the
option is assigned an obligation to
fulfill the terms of the contract. The
hypothetical writer of a $20 October
Intel put must buy 100 shares, paying
$2,000 in return.
The mechanics of matching an
exercising option holder with an
assigned option writer is handled
behind the scenes by the Options
Clearing Corporation. But once
assigned, the writer must fulfill his
end of the bargain, either delivering
shares already owned, buying shares
on the open market, or shorting shares
and delivering those in fulfillment of
the contract (of course, the writer then
has the obligation to go back at some
point and cover the short). Exercise
at expiration is generally automatic
and handled by the Options Clearing
Corporation.

options.fool.com Options U: Essentials Motley Fool Options 13