Call Option Buying

Call options are arguably the easiest trading strategy there is.

What are options:  Options are contracts to buy or sell stock at a given price by a certain date.

Options come in two varieties: Calls and Puts.

Both calls and puts grant the buyer the right, but not the obligation, to buy or sell stock.

Both calls and puts impose on the seller the obligation to sell stock.

As the chart above shows, one can either buy or sell both calls and puts.  Whether one buys or sells these options grants him or her either a right or an obligation.

Some concepts to understand about options: 

 

1. Options are listed in strike prices at specific intervals, depending on the underlying stock price.
2. Options are said to be wasting assets because they have expiration dates.
3. Stock prices are listed as for a single share of stock.
4. Each option controls 100 shares of stock.
5. The price of an option is comprised of intrinsic and time value.
6. Options expire typically on the third Saturday of every month.

How does this work in practice:  Firstly, I will not calculate commissions for the sake of this article.  Commissions vary widely from broker to broker, but some excellent brokers have very reasonable commission costs.

Above I stated that call options grants the buyer (owner) the right to buy stock at a certain price before a certain date.  Suppose you buy a Microsoft (symbol MSFT) $33 call option with an expiration date of December 2012.  What this means is that you want to own the right (but not the obligation) to purchase MSFT by the latest December 2012 at a limit price of $33.  For that right, you must pay a price, and as of closing prices September 25, 2012, the December 2012 $33 call was going for $0.34.  You have just purchased the right to buy MSFT for $33, and your breakeven cost would be $33.34, to account for the cost of the call option.  Why would you want to buy this call option?  Because you think that MSFT is going higher.  At today's close, MSFT traded at $30.78.  If it rises by December expiration to $35, and your breakeven is $33.34, you're ahead of the game by $1.66, or $166.00, because you can exercise your call option and buy it at $33.00, which is cheaper than going out on the open market to purchase the stock.  Moreover, if you buy 100 shares of MSFT at the current price ($30.78), you would have to spend $3078.00 ($30.78 x 100) - (remember, stock prices are listed in single-share prices) but buying an out-of-the-money (OTM) call option only costs you $34.00 ($0.34 x 100).  A dramatic difference.

Since I introduced the term "out-of-the-money" above, let's explain this term.  All options (puts and calls) have strike prices.  For calls, if the strike price is lower than current market price, the option is said to be in-the-money; if exactly at the current market price, the option is said to be at-the-money; and if above current market price, it is said to be out-of-the-money.  The reverse is true for puts, where if the strike price is under the current market price, it is said to be out-of-the-money; if exactly at current market price, the option is said to be at-the-money, and if above current market price, the option is said to be in-the-money.  Let's put this in a table, as above.  Let's stay with MSFT, closing today at $30.78.

CALLS

• ITM - $30.00
• ATM - $30.78
• OTM - $33.00

PUTS

• ITM - $33.00
• ATM - $30.78
• OTM - $30.00

Strike prices are usually listed in 2.5, 5 and $10, and above, so you will not see a strike price of $30.78.  The ATM figure above is for illustration only.

Intrinsic and Time Value.  Each option consists of Time Value.  But not so with Intrinsic Value.  In the case of MSFT, if the current market price is $30.78, a $33 call option is said to be "out of the money" because its entire cost consists of time value only.  Time value is the portion of the option that is the so-called wasting part.  You may ask, what is time value? Time value refers to the portion of the option that covers the time chance of the stock moving that high.  For example, in weather, you may hear forecasts of a "15 percent chance of a hurricane occurring in December."  That would be equivalent to a "time" chance.  The more time you give an option to "cook," so to speak, the more you should pay for it.

You no doubt have heard that approximately 80 percent of all options expire worthless.  This refers specifically to the time value of an option.  It is this portion that erodes with time.

To repeat, if MSFT rises to $35.00 by the December 2012 expiration, it would be more profitable to purchase MSFT at your agreed-upon price of $33.00 than to go to the open marketplace and purchase it at $35.00.  You paid $0.34 for the privilege of buying it at $33.00, so your total out-of-pocket in this case would be $33.34 - still lower than the market price of $35.00.  In fact, what you have done by purchasing that call option is that you have effectively "locked up" a purchase price of $33.00 per share, no matter how high MSFT rises by the expiration date.

Limited risk:  We have been talking about how to profit if the price of MSFT rises to $33.00 by expiration.  But what happens if it declines?  If MSFT declines from its current price, or simply does not rise enough to cover your breakeven of $33.34, you would lose the entire cost of your option of $0.34, or $34.00 ($0.34 x 100 shares).  But that is the most you can lose.  That's one of the benefits of options - that they limit your risk.  That is precisely what the "futures" markets do - they try to lock up prices in the future and not run the risk of having them increase inordinately.

The title of this article is, Why I don't buy call options.  With the above explanation, you might think that limiting my risk to "only" $34.00 seems like a wonderful idea.  It might be, but consider that if I buy a call option, I need the underlying stock to do two things: move up, and move up in a timely manner.  When you hear the axiom that 80 percent of all options expire worthless, that is what they are referring to: the chances of a stock moving to a target price in a given period of time frequently does not occur, and many (80 percent) call options expire.

Nice Way to Generate Steady Income - The Covered Calls

What are covered calls?  "Covered calls" is an options-trading technique, whereby 100-share lots of stocks are "rented out" for a period of time.  Let's see how this works.

Suppose you own a house that you would like to rent out for a period of time, say, six months.  You charge $900 per month for a total of $5400.  At the end of the six months, you either rent it again, or keep it vacant, as you wish.  The house is yours to do with as you please, but clearly, it is more profitable to rent it out.

The same thing goes for stocks.  Suppose you own 500 shares of Microsoft (MSFT) that you have accumulated over the years.  It does pay a dividend, but you believe you can earn more by renting out your stock.  What? Rent out my stock? Yes. 

Here is how you do it.

First, a few basics.  As the name implies, you would be doing "covered calls."  Options come in two forms: calls and puts.  Here, we are talking about call options, and they are "covered" because they cover stock that you already own.  Options, like rent, come with expiration dates.  They also are listed by strike prices. 

A Great Way to Make Money

Insurance companies are the ideal businesses.  Well, almost.

Stock options have gotten a bad rap.  And yet, some strategies are so safe, the government permits them in IRA accounts. 

Some think that option techniques are complicated, full of jargon, full or arcane numbers and obscure formulas.  That may be true in academic circles, but for practical application, it needn't be.  There are some principles that must be understood, but they are not complicated.  For example, you know that to lose weight, you need to take in fewer calories than you expend.  That's it; it's really no more complicated than that.  However, the application of that formula has brought many to tears.  For another analogy, you already know that you should save a certain amount of your paycheck for a rainy day.  Again, simple formula, but perhaps difficult implementation.  But the difficulty arises not from the formula itself, but rather because of people's unwillingness to play the game, people's resistance to learning the rules of the game, and the almost universal desire to have things handed to them on a platter.

What if I told you that it's easy to make money? Your tendency would be to resist my assertion, perhaps pointing out to me that if it were so easy, everybody would be rich.  True, but the problem is that "everybody" does not apply the rules, and indeed, does not even bother to play the game.

Selling naked puts is my favorite strategy.  Some readers may have heard that naked puts are risky.  In fact, they are no more risky than covered calls, the same strategy permitted by the government in retirement accounts.  So what does selling naked puts entail?

Without getting too elaborate, options come in two varieties: calls and puts.  Calls represent the right to buy; puts represent the right to sell.  One can either buy or sell either calls or puts.  Both calls and puts cover lots of 100 shares of stock, where 1 option controls 100 shares.  Both calls and puts are represented by strike prices.  Strike prices are either at the current market price of the stock, in this case MSFT at $31 and are known as at the money (ATM), below the current market price of the stock are out of the money or in the money (OTM for puts, ITM for calls), or above the current market price of the stock, known as in the money for puts and out of the money for calls (ITM for puts, OTM for calls).  With MSFT currently at $31,

                        PUTS              CALLS

Strike 30                    OTM                  ITM

Strike 31                    ATM                  ATM

Strike 32                    ITM                    OTM

Moreover, options are "wasting assets" because the life of the option has a time limit.  Let's also stipulate that options are traded within a brokerage account, such as Fidelity or OptionsXpress, or any number of other brokers. 

Since this article is about selling naked puts, let's explain this a bit more deeply.

A put option represents the right to sell, specifically, to sell a stock.  Frequently, people will buy a put option to protect their portfolio.  How does that work?  Suppose you own 100 shares of Microsoft (symbol: MSFT) that you've been accumulating over the years, or received as a gift.  At its current price of $31, your 100 shares are worth $3,100.  If you are worried about the stock falling and losing some of your money, you would buy a put option at, say, a strike price of $30.  Recall that a put represents the right to sell (a stock).  If MSFT falls to $27, you own the right to sell the stock at $30, which was the strike price of the put you purchased. So, it would not bother you that MSFT had fallen to $27 if you own the right to sell it at $30.  So, the put gives its owner the right to sell the respective stock at the strike of the put option.  Recall, too, that the put option has a time limit - the longer the expiration date, the longer you can hold onto this protection of MSFT at $30. 

Now, if you bought the put option, someone had to sell it to you.  Why would someone wish to do that?  Because when you sell something, anything, you get the money (and likewise, when you buy something, you spend the money).  And what was the intention of that seller of the put? That seller essentially took on the risk that MSFT would stay at its current price, and not fall.  For that risk, the seller received a premium (from the buyer who wants to protect his MSFT shares).  In this case, the seller sold a naked put, meaning that his/her put does not have a corresponding position.  It's out there, alone, unsupported.  He is taking a risk, and for that, he is being paid. 

Imagine the same situation in real estate.  You, as a buyer, are interested in buying property in this depressed market, thinking that you'll snatch a real bargain.  You look at several properties, and find one that you really love.  But you want to keep your door open, to find other properties that are even better.  So you give the seller an option to buy the property at, say, $200K.  You are buying an option to buy that property (while the seller is selling you an option to buy the property) at a certain price by a certain date, say 6 months.  And for the privilege of "holding" the property at $200K for the next 6 months, you are willing to pay the seller a premium to cover his risk of higher prices.  Why is that a risk for the seller? Because the market may suddenly switch course and rocket higher, while he, the seller, has just committed to sell you his property at the lower price of $200K.  If, at the end of 6 months, you have not completed your contract by buying the house, the seller keeps the premium you paid. 

So it is with put options.  By selling a put, the seller collects a premium for essentially selling insurance on the stock, taking on the risk that the stock would fall.  For that, he receives a premium, just as insurance companies do.  But under the right conditions, expiration of the option term arrives and the stock has not fallen, the entire premium remains in the seller's pocket. 

Let's see how this works out in the "real" world.

MSFT's closing price as of 09/07/2012 was $30.95.  For the sake of this article, let's call it $31.  Suppose someone wants to sell a put on MSFT at a strike of $30 expiring in December 2012.  That put is currently priced at $1.12.  Please recall that options are represented in lots of 100, so the $1.12 would really be $112.  He receives the $112 in his account the very next day, and he is free to use that money as he sees fit.  What the seller is betting is that MSFT will not go below $30 by expiration December, and he will keep his entire premium of $112. 

But wait, there is more!

In order for a person to be able to sell this insurance, the brokerage house requests a certain collateral be put up against the risk of the stock falling.  The formula for such collateral is not complicated, and is as follows:

Price of stock x20 percent + premium received - any out-of-the-money amount

Wait, what's "out of the money"? As depicted above, a put strike below the current market price is known as out of the money (OTM).

So, accounting for an option controlling 100 shares, let's multiply our numbers by 100.  Plugging in the numbers into the formula, we get the following:

$3100 x 20 percent =$620 + $112 (premium received) - $100 (OTM amount) = $632 as collateral.

If December expiration arrives and MSFT is still above $30, then the put expires worthless, and you, the seller, get to keep the entire $112 you received as premium.  But, you say, this isn't such a big deal!  No, not yet, not until you realize that $112 represents 17.72 percent return on your money in three months ($112/$632=17.72 percent).

If 17.72 percent return in three months is not to your liking, imaging going out farther than December, to, say, January of 2014.  Now, the $30 put premium expiring in January of 2014 is $3.85, or $385 for each contract that controls 100 shares.  Your return in this case would be:

            $3100 x 20 percent=$620 + $385 - $100=$905.

And your return percentage:  42.54 percent for a year and a half.  Not bad in my book.

Synthetic equivalents - Bull call spread/Bull put spread

Following Kenneth's description, assuming the same example, AAPL Sep. expiry (3 weeks away) an OTM bull call spread at the $710-730 spread wtih a delta that's practically nonexistent, vs the same strike ($710-730) bull put spread with a delta of about 0.99: if AAPL goes up in price, as we assume if we are proposing bull strategies, the ITM bull put spread with a delta of .99 would move $0.99 for every $1 in AAPL's price increase (more or less, allowing for the other Greeks to play along, including theta with a short expiry). Still, the put spread would move considerably in favor of the seller; while the OTM bull call spread with a delta of 0, more or less, would need a huge move up in price of AAPL to register any change at all. With a tiny delta, every $1 move in the underlying stock moves its corresponding call options only a tiny bit, and with the theta getting involved, the underlying would need to move up a very large amount before the delta begins to cooperate.

I guess we're all going to be debating this until it's time to change the expiry. In my opinion, an deep OTM bull call spread with a short expiry is a lottery of the worst kind - it's cheap, but it's also very unlikely to deliver good results. And whether or not you consider the two strategies to be synthetic equivalents (which they are), they nevertheless do not produce the same results. For an anticipated bullish move, I would MUCH rather be in a deep ITM bull put spread that dances to the music, than be a wallflower waiting patiently to be asked to dance.

As of Sep. 2, 2012, AAPL options are listed as follows:

Sep. 710 call = $0.21 x 0.26, delta 0.0277

Sep. 730 call = 0.08 x 0.11, delta 0.0112

 

Sep. 710 put = 43.90 x 45.60, delta -0.9864

Sep. 730 put = 63.75 x 66.55, delta -.9634

 

 

The "Greeks"

The "Greeks" are so called because they refer to five Greek letters - delta, theta, gamma, vega and rho - that are used to measure risk of an option.  An option is a financial instrument that is used for a variety of purposes, from protection of a stock or portfolio to generating income (please see Option Basics).  Options have a finite life, unlike the stocks the represent.  Because of this predetermined lifespan, options are considered risky instruments.  In truth, one ought to express this as options carry risk, rather than stating that they are risky, because in fact, options are not inherently risky.  But because they carry risk, that risk is measured by various factors, such as time to expiration, strike price, volatility, etc.

Calculations that measure risk are called Greeks.  These calculations were formulated and coined as the Greeks by three Nobel-prize winning academics, Fischer Black, Myron Scholes and Robert Merton.  For an exhaustive review of the Black-Scholes Model, please see http://www.investopedia.com/terms/b/blackscholes.asp.

In its short form, the Greeks calculate how an option price will change with the passage of time, change in the price of the underlying instrument, and other market conditions. 

Delta refers to the sensitivity or relationship of an options price relative to a $1 change in the price of the underlying instrument.  Delta is expressed from 0 to 100 for calls and from -0 to -100 for puts.  The delta value will change according to the strike price of an option, whether it is in the money (ITM) or out of the money (OTM).  Delta does not change at a uniform rate, because the underlying instrument does not change at a uniform rate.  For example, an option might have a strike price $10 below the current stock price, with an expiration one month hence.  However, the stock may remain very close to its current price for days, or even weeks, yet the option itself is a moving target by virtue of the passage of time.  Therefore, the delta (as well as the other Greeks used to measure its risk) will move and change over time.   Enter Gamma.

Gamma measures how delta will change based on a change in price of the underlying instrument. 

Theta measures how delta will change based on the time left to expiration.

Vega refers to how delta will respond to a change in volatility.

Rho refers to how much an option price changes relative to a change in interest rates. 

I have attempted to synthesize these definitions, but you may obtain additional information from https://www.thinkorswim.com/tos/displayPage.tos?webpage=lessonGreeks.

Adjusting the Legs

Yesterday, I set up a Strangle With a Twist on Netflix (NFLX) right before earnings.  NFLX came out with earnings which were very positive, but "guided" lower.  The stock dropped in after-hour trading, and is trading considerably lower this morning, down about $16.75 at this writing.

Recall that I had two spreads on the stock: May 2011 $260-$265 Bull Call Spread and the May 2011 $235-$240 Bull Put Spread.  Both spreads are bullish; both spreads were set to expire May 2011.

With the stock currently down about $16.75, the call options are trading lower (the call options are currently out of the money - OTM), while the put options are trading higher (the put options are currently in the money - ITM), I have executed a few adjustments, as follows:

I bought to close (BTC) the May 2011 $265 call options for $2.90 ($290 per contract).  I sold them yesterday at $9.75 ($975 per contract), so my profit on this leg is $6.85 ($685 per contract).  That leaves a Long Call at the $260 strike expiring May 2011.  This is a Long Call (Long means that I own this position), therefore, there is no Margin Requirement.

I sold to close (STC) the May 2011 $235 put options for $10.35 ($1,035 per contract).  I bought them yesterday at $8.25 (of $825 per contract), so my profit on this leg is $2.10 ($210 per contract).  That leaves a Naked Put at the $240 strike expiring May 2011.  This is a naked position, therefore, there is a Margin Requirement of $5,977. 00.

Why did I adjust these legs?  From past experience, it seems that there is a knee-jerk reaction to negative news, and I am betting that the selling action is overdone, and the stock will recover.  So far, by removing those two legs (the short call* and the long put*), I have put $895 back into my account.  I opened both spreads yesterday at almost no cost to me.  My risk here is that the stock will not recover to the $240 strike naked put, in which case the stock will be put to me, and I will be obligated to buy it at the strike of $240 (refer to the lexicon for definitions).  As expiration approaches, I can reevaluate my position to see if the fundamentals of the stock are still interesting enough to wish to hold the stock, and if not, I can simply buy back to close that naked put, thereby relieving myself of that obligation.  In the event I do wish to allow the stock to be put to me, my break-even cost would be $240 (the strike price) less the profit of $895 I just realized, or $231.05.  Looking out to some long-term call options, selling a covered call would bring down the price even more.

With the stock currently trading at around $236, the $240 strike naked put is trading at around $12, which is $4 in the money (ITM) - $240-$236 - and a full $8 out of the money (OTM), or time value.  With May expiration being just 3 weeks away, the Theta of the option erodes extremely fast.  The Theta refers to how much value an option price will lose with every day that passes.  The closer to expiration, the faster an option loses value.

On May 11, 2011, the market started to jiggle (to the downside) a bit more than I like.  NFLX was trading up to $241, but then regressed down to $238, so I decided to roll out my naked puts to June 2011.  By rolling out, I closed (BTC) my May 2011 open position $240 Naked Put at $6.31 and opened (STO) a new June 2011 $240 Naked Put for $12.61, thus pocketing a profit on the May position of $3.74 ($374), and taking in a premium of $12.61 per contract ($1261) for the new June 2011 naked put.

Time Value vs. Intrinsic Value

Recall that options come in two varieties: Calls and Puts.  Both calls and puts can be bought or sold.  That's a total of four possible moves, but within those four moves are innumerable possible permutations.  For the sake of this very simple explanation, let's focus on what is meant to Time Value and Intrinsic Value.

First, Intrinsic Value.  As the term suggests, intrinsic means inherent, built-in, real value.  Let's consider a call option on Apple Computer (AAPL).  The stock is currently trading at about $350.  If you buy a call option at a $320 strike price expiring in May 2011, that means you are buying the right to buy AAPL at $320 on or before May 20, 2011.  For that right, you would pay $33.60 on the ask (you buy at the ask and sell at the bid).  For 1 contract, the total cost would be $3360.  With the stock currently around $350, that means that a full $30 of the cost of the $320 call is intrinsic value, or in the money (ITM).  You are therefore buying some "real meat," if you will.  You are buying some portion of the stock itself.  The remaining cost of the option ($33.60-$30.00=$3.60) is Time Value. 

All options, both calls and puts, have what is known as intrinsic value and time value.  Time value is that portion of the option that erodes over time.  It is much cheaper, dollar-wise, to purchase only time value (out of the money OTM) call options, but the risk is greater.  More on that later.  In the case of AAPL, as above, by spending $3360, you are actually positioning yourself to profit very closely to the movement of the stock itself; if AAPL rises by $1, your call option is likely to appreciate by a similar amount (called the delta - more later).  The delta of ITM call options is significantly higher than deltas for time value call options.

More Terminology

Intrinsic value/time value.

When they say that 85% of options expire worthless, "they" are correct.  So what you want is to profit from that 85%.  Expound:

Covered Calls

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Selling covered calls is a way to enhance returns on stock you already own.  You are in effect using your stock as rental property, collecting monthly or semi-annual royalties on that stock.  In return, you are agreeing to part with that stock should it come up to a certain price level.  Selling covered calls generates income that also reduces your cost basis on the stock.  Let's say you have own Altria (MO) for years.  It has paid regular dividends, and periodically, you have purchased more shares.  You now have about 500 shares, and would be happy to generate more money out of that stock than mere dividends.  Why not collect some (rental) money while waiting for your money to grow or waiting for the dividends?  It is just sitting in a brokerage account; why not "use" it to enhance your returns.  MO closing price on April 21, 2011 was $26.06.  The December 2011 $27 strike calls are bidding $.75.  If you sell 5 contracts to cover your 500 shares, you will receive $.75 x 500=$375.00 into your account immediately.  The sale of a covered call means that should MO rise to $27.00 by the December expiration, you agree to part with your 500 shares at the strike price of $27.00. 

What could go wrong?  MO could crash.  In this example, you received $.75 per share for agreeing to sell your stock at $27.  That brings the break-even price down to $25.31 ($26.06 - $.75).  But if MO crashes down to, say, $20.00, clearly that $.75 does very little to mitigate that loss.  Then again, with or without selling the covered call, MO could still crash.

Covered calls are a terrific strategy to generate income from range-bound to slightly bullish stocks.

Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.

In the Money (ITM)/Out of the Money (OTM)

Have you heard these terms and wondered what they mean?

Options are financial instruments designed to take advantage of price movements of stocks.  This is a very simplistic definition, because options actually involve many more financial maneuvers than just stocks.  Let's stick with stocks for now.  Options come in two types: Calls and Puts.  Both Calls and Puts can be bought or sold.  Although that represents four directions, in reality, options can be "played" in an infinite variety of moves, directions, expectations and techniques.  There are "Greeks" which refer to Green terminology to identify forces that affect the movement of options; there are expiration dates; and there are strike prices. 

Some people think of Call options as ways to buy a position, but that is erroneous, as Calls can also be sold.  So it is with Put options.  Even though there is a common misconception that Put options are used to sell a stock, Puts can also be bought, or, as is the mainstay of this blog, can be sold "naked" to generate income.

For both Calls and Puts, the strike price determines if the option is In the Money (ITM) or Out of the Money (OTM).  In a previous entry, I discussed BTU (Peabody Energy Corporation).  The closing price as of Thursday, April 21, 2011 was $66.02.  I sold a Naked Put expiring January 2013 at the $65.00 strike price and received a premium of $1120 immediately into my account.  That means that between now and January of 2013, if BTU remains above $65, I will get to keep the entire $1120 that I received.  Based on a Margin Requirement of $2340, my return on investment (ROI) is 47.86%.  Since BTU closed at $66.02, and the strike price is $65, my Naked Put is said to be $1.02 out of the money (OTM). 

In the case of Puts, if the market price of the stock is HIGHER than the strike price, it is said to be OTM.  Conversely, if the stock price is LOWER than the strike price, it is said to be ITM.

In the case of Calls, if the stock market price is HIGHER than the strike price, it is said to be ITM.  Conversely, if the stock price is LOWER than the strike price, it is said to be OTM.