This is episode 3 of Understanding Options for Newbs, so by now we know what options are and what they mean. This is going to be a short, but important post. Plus, the next one’s going to be a doozy. =)
The next exceedingly important and fundamentally basic thing you need to know is that options contracts expire. Yes, that’s right, at some point every option will be rendered completely worthless regardless of the price it was originally purchased at. So that Under Armour option you just purchased, assuming it was a May option, will be worth exactly $0.00 once that closing bell sounds on Friday, May 15, 2009. What does that mean for you? Apart from the expiration date affecting the price of that option on a daily basis, it means that you had better know if you want to sell, exercise or hold the option (and let it expire) well before the expiration date.
Oftentimes it’s better to hold the option and let it die (if you’ve gotten to that point) than to exercise it. I mention this specifically if you’re the kind of person to convince yourself, “Oh I’m going to throw away all that money I spent on that option if I let it expire, I’ll just exercise it and it will have been partially worth it.” What’s really worse, holding an expiring option and losing $200, or exercising the option and spending $2,000 for one hundred shares of a stock that is probably not even gaining in value (otherwise you should have sold it, hopefully, for a profit!).
Next time we’ll discuss how options are valued. Without understanding why those contracts are valued at what they are, you might wonder why that call option you bought is decreasing in value even though the stock itself hasn’t gone down, or may even went up a little. Stay tuned, same Roaring Time, same Roaring Channel!