Learn Options

The Basics of Options

Most people have no clue about options. They may have heard them mentioned on the news. They may have heard stories of aunts or uncles who lost everything because of risky options trading. Most people lose money with options due to a lack of knowledge about them. Learning about options can open a new world of investment choices for your portfolio.

Note: this article only covers the basics of options. It does not go into how they can be used nor does it specify how to properly make money from them. You should not misconstrue the information provided in this article as any kind of financial advice. Please seek the advice of a qualified financial professional!

Definition

An option is a contract. This contract gives the holder (buyer) the right, but not the obligation, to purchase a predetermined number of shares in an agreed upon company (stock). They can do this on or before the date the contract expires. The price is also agreed upon and is specified in the terms of the contract.
This describes call options. More on put options below!

This is a bit formal as a definition so let me clarify by way of example.

Suppose company XYZ is selling for $50 per share. If you wanted to pick up 100 shares, you would need to purchase $5,000 worth of the stock. This does not factor in margin accounts or commissions, to keep it simple.

Now suppose someone approaches you and says that you can still get 100 shares of XYZ for $50 per share, but you won't have to lay out that money initially. You can wait up to an agreed upon date. Let's say that date is three months from now.

With this agreement, you can decide at any point within that three month period to purchase the 100 shares for $50 per share. All that is needed for this agreement if for you to pay this person a fee right now. You both agree that the price of this fee is $3.00 per share or $300 ($3 x 100 shares).

Before we go further, let's define some terminology based on the above example!

  • Stock Price - This is the price of the stock, and fluctuates every second. If you asked your broker what the price of XYZ stock is selling for, this would be the price quoted.
  • Strike Price - this is the agreed upon price that you will purchase the stock for, should you decide to buy the stock within the predefined period. In the above example, the strike price is $50.
  • Expiration Date - you can buy the shares at any point before or at this date. In the above example, it is three months from now.
  • Exercise - this is the term used when you want to buy the 100 shares at the strike price. If you decided to do so before the expiration date, you would pay $50 per share for a total of $5,000.
  • Premium - this is the amount that the agreement costs. In the scenario, you and the seller agreed this would be $3.00 per share for $300 ($3.00 x 100 shares).

Restating the scenario with the proper terminology would give:

You are given the right, but not the obligation, to buy within the expiration date of three months from now (whatever that date happens to be), 100 shares of XYZ stock at strike price of $50, no matter what the price of XYZ is when you decide to buy. As long as it is before the expiration date.

You can also choose not to exercise this agreement and let it expire worthless. No matter what you decide, the $300 is the seller's to keep. You will lose that amount whether you exercise or not!

Now that we have all the components of this contract, let's take a look at the scenarios that may occur at the expiration date:

  • The stock price falls to $30 per share.
  • The stock price stays on or around $50 per share.
  • The stock price jumps to $80 per share.

The Stock Price Falls to $30 Per Share

Under this scenario, you are not required to buy the stock at $50. Why would you choose to do that when the stock is selling for $30? In this instance, you would simply let the stock expire. Your total loss is $300, which is the premium you paid for the agreement.

The Stock Price Stays Close to $50 Per Share

You could exercise your option under this scenario. But, if the stock was at $50, the transaction becomes an even exchange. It is still a losing proposition for you since you paid the premium of $300. Under this scenario, you would likely let it expire.

This brings up an interesting point. Your breakeven point is $53 per share. You must always factor in what you paid as a premium when determining your breakeven point. Since you paid $3 per share, you add that $3 to the strike price to arrive at your breakeven point. Any price above $53 starts to become profitable for you.

The Price Jumps to $70 Per Share

I stated before that your breakeven is $53 per share. This is your strike price plus the premium you paid ($3.00). $70 is definitely much more than $53. Therefore, you would exercise the terms of the agreement. But, how much do you pay for the stock?

If you guessed $50, you are right!

Here is what makes options so popular for those who understand more about them. You would pay $50 per share ($50 x 100 shares = $5,000). Then, you could immediately sell the shares on the open market for $70 per share ($70 x 100 shares = $7,000). This gives you a gain of $2,000 - the premium paid ($300) for a net of $1700.

Why Go Through All of This?

It seems like options over-complicate the landscape. You could have simply purchased the stock for $50 and sold it for $70. The problem is, if you bought the stock outright and it went to $30 per share, you would be sitting on a $2,000 loss. Perhaps the stock would regain its footing eventually. But, if you have ever bought stocks before and suffered a loss, it can take quite some time to get back the amount lost, if it happens at all.

Even a paper loss is money that is not working towards increasing your wealth!

The only risk you took going into this agreement was the $300 premium. That's it! The stock could have lost 100% of its value and your loss still would have been only $300.

Let's compare the returns when the stock rose to $70 on or before expiration:

  • Buy the stock direct:  $2,000/$5,000 = 40%
  • Exercise the option: $1,700 / $300 = 566%

Note: annualizing returns not considered since the time frame is same for both.

Another Type of Option Contract

The scenario described above was for call options. These are options where the buyer holds the belief that the stock is going to go higher in the limited time on or before the expiration date. There is also an option contract known as a put. People unfamiliar with options have a more difficult time with puts as a concept. Essentially, you will sell the shares at the agreed upon strike price rather than buy. The confusion comes probably because it's difficult to imagine selling something you don't own, i.e., the stock.

As an example of a put using a similar scenario above, suppose you felt that XYZ stock was going to drop in value within the next three months. You enter in a contract to sell 100 shares at $50 on or before the three month expiration date. If the stock drops to $30, you would buy 100 shares of the stock at the market price of $30, and immediately sell those 100 shares to the option seller for $50 per share. The net profit is still $1700.

Another reason newcomers get tripped up with put options is there is no equivalent to direct selling the stock. With call options, you can choose to buy the stock outright or enter into a call option agreement. You may believe that short selling a stock is the equivalent with puts, but it really isn't. With puts, you don't have to ask your broker for permission to borrow the shares as you do with short selling.

Who Sells the Options?

You'll notice I haven't written much about that person who agrees to sell you the options contract. Who is he (or she) and how can you trust the contract will be executed properly?

Option Sellers

If you were to actually enter into a deal with an individual using the terms above, it is highly likely he will be nowhere to be found come time for exercise. You will be out the $300 and very likely have no recourse for the situation.

Luckily, you don't deal with individuals when purchasing options. You deal with an options exchange. The exchange guarantees the contract. If the seller does not come through, the options exchange will see to it that you get your money as defined in the terms of the contract. They will deal with the seller on their own.

You won't even know who the seller is. In fact, when you enter in an agreement, it's highly unlikely that same seller will be the one that honors the exercise. The good news is you don't have to concern yourself since the exchange will honor the agreement. This is why options work.

Why Would Sellers Write Options Contracts?

In theory, an options seller has unlimited risk. Suppose under the above scenario that the price of XYZ went to $1,000 on or before expiration, rather than $70. The seller (or the exchange) would have to still sell you the shares for $50. If they didn't own the shares (and many of them don't), they would have to buy the shares at the market price of $1,000 and sell it for $50. If the price went to $2,000 per share, they would need to buy it at that price, and so on.

In reality, it's rare that stocks will jump that high in the short duration of three months. If the stock jumps after expiration, the option seller does not have to worry about that because the obligation has passed. They keep the premium and move onto the next opportunity.

Man with broken umbrella representing risk

This should give you some inclination as to the risk involved. Writing an option contract for three months is a relatively safe bet for many stocks, especially the further away from the strike price it goes. Now, imagine if the expiration date is for a year away. Wouldn't the option seller need to charge significantly more for that contract to be compensated for the extra risk? The answer is yes.

Where options gets complicated is in how they are priced. There are mathematical formulas that help derive the price based on a bunch of factors. This is way beyond the scope of a basic article on options. But, this explanation should help you appreciate the risks involved for the sellers.

Sellers are enamored by the statistic that most options contracts expire worthless. When they sell a bunch of them, this can be a quick way to capture premium. Remember, they never have to pay back the premium. It is theirs to keep. Even if a few contracts here or there get exercised, it's unlikely they will set back the sellers since they are making significant amounts with their overall portfolio of premiums over time.

You can think of it from their perspective almost like they are underwriters for insurance. When you take out a car insurance policy, the agent will consider several factors including your age, where you live, your health (you could suffer a heart attack while driving), and your financial situation, etc. Professional options sellers have their own set of risks factors that they evaluate. They apply them to the market conditions overall as well as factors that may influence the stocks they write the options on.

As will be seen in the next section, sellers do not have to hang onto to losing positions. They have a way of getting out of their obligations early, albeit at a loss.

Exercising Not Needed to Profit with Options

One aspect of options is the contracts themselves are tradable on the exchange. For instance, if you paid $3 (x100) premium, and the stock price increased by $20 at any time before or at expiration, the value of the contract goes up as well. The price of the contract depends on many factors. However, if the value of the stock is well above the strike price, you can expect the price to be at least the difference between the stock price and the strike price.

This is for call options only. See below for put options explanation.

So, if the price of the stock increased from $50 to $70, for simplicity, lets assume the price of the option contract increased to $20. It probably will be more. You don't have to exercise to make money on this situation. You can simply trade your contract for $20, making a profit of $17 ($20 - $3 premium). As usual, multiply by 100 since most option contracts are for 100 shares. This represents a gain of $1700.

As mentioned before, sellers also have the capability to get out of their positions. If they see early on that a position is not going as planned, they simply close out the position by taking an opposite position, in their case, they buy an equal number of contracts to offset the ones they sold. From their perspective, it's better to take a small loss than let it continue into a huge loss.

Some sellers may choose to close out their positions when they have recognized a tiny profit. They may give up further gains by doing this, but they are no longer at risk of the position going against them. It all depends on their selling strategy!

Options Are Complicated

You can see by the length of this article there is a lot of information regarding options. Interestingly, I haven't even touched the surface on the amount of information that exists for this concept. There are all contains of exotic variations that people come up with that they believe can solve any financial situation. Options can be used as insurance on a portfolio or for income appreciation (covered calls or writing naked calls, etc).

Equations representing complicated

Then, there is the whole risk assessment that helps to determine the prices of these options. To make matters worse, you can have strike prices at several levels near or away from the stock price. Multiply this by the different expiration dates that get created. Some of them go out for two years or so. The price of each of these variations change with every tick of the stock price.

Conclusion

The purpose of this article was to give you a high level understanding of options contracts. It is not a wise move to use what you read here to start trading options. There are too many variables and complications. This article should serve as nothing more than a starting point in the vast learning requirements needed before you can begin taking advantage of options.

I can practically guarantee that you will lose money if you try to trade options based on the information provided within this article and stopped your education here!

Please heed this warning. There is too much at stake not to do so!

I am a big fan of options, but know that I have many years experience in trading them. I still don't know all there is to know about them. They can be a fantastic way to earn money but can cost you dearly if you don't know what you are doing.

I intend to continue adding options resources on this website to further your education. If this is something you are interested in learning more about, feel free to let me know in the comments below.

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