What are options?
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What are options

What are Options

 

Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.

They are a derivative, which means its value is derived from the value of the stock or other instrument.

There are 2 categories of options that you must be familiar with:

 

  • A Call option gives the trader the right but not the obligation to buy shares (100 per options contract) of a stock at a predetermined price before the future expiration date

 

  • A Put option gives the trader the right to sell shares (100 per options contract) at a predetermined price before the future expiration date

 

 

WHY TRADING OPTIONS

 

 

There are a handful of reasons that may prompt you to explore options further and these are the ones that interested us:

 

  • Flexibility – Options can be used for hedging purposes, simple directional plays or even finding profits in markets that are oscillating between two price extremes.  You will learn about terms such as Iron Condors, straddles and butterflies but in this introduction, simply consider those part of an overall options trading playbook.  You may find yourself having great success with keeping things simple with basic calls and puts.

 

  • For now just understand that you don’t have to be right on the direction of the market in order to make money trading options.

 

  • Leverage – You are able to purchase or sell 100 shares (minimum for an options contract) of an equity such as a stock for only a percentage of what you would pay to own the stock outright.  Let’s take a simple example of stock ABC where each share is $50.  If you were interested in making a bullish play with this stock, you would need to front $5000 for 100 shares ($50/share X 100).  You can control or take advantage of a move in that stock through a simple options play for $500.

 

  • Risk Control – Success in trading hinges on your ability to control your risk in any instrument you are trading.  If you are trading futures or stocks you can actually lose more through slippage and gaps then you originally planned.  Your risk with option is the premium you paid for the options contract.  Be able to control with accuracy the financial risk you are taking is one of the huge benefits of getting involved with options trading.

 

 

WHAT MAKES UP AN OPTIONS CONTRACT

 

 

Earlier we touched on two elements of an options contract, calls and puts. Those are not the only aspects of the contract and you should be familiar with the following:

 

  • What security the option contract covers – This is called the underlying asset and it simply is the stock such as Google that you will be trading the option with.

 

  • Number of shares – One options contract covers 100 shares of the stock (at a much better price).  You are able to trade more than one contract.

 

  • Strike price – Quite simply, this is the price that has been agreed upon to buy/sell the underlying instrument (such as Google) before the expiration date.

 

  • Expiration date – This is the day that the contract expires and it is usually on the third Friday of the expiration months.

 

These variables make up an Options contract

 

Options Examples
Underlying Asset Stock ABC
Option Category Call
Numbers Of Contracts 1( 1=100 Shares )
Strike Price $100
Expiration June

 

 

WHAT MAKES UP THE PRICE OF THE OPTION

 

 

Several variables are taken into account when the price of the option is calculated.  Keep in mind that there is a “wildcard” when it comes to the pricing of options:  Volatility.

 

Volatility constantly changes throughout each trading session. So the pricing model actually works backwards to determine which level of volatility is being used to generate the current price of an option. It takes the 5 known inputs and backs them out of the current option price being quoted to get the volatility.

 

 

YOUR OPTIONS STRIKE PRICE

 

Remember that the strike price is the agreed upon amount that the underlying asset, if exercised, will be bought or sold at.  We can compare the strike price with the actual price of the asset we are trading through the options contract. We call this relationship intrinsic value and will be a determining fa

 

  • At the money:  This is where the strike price and the stock price is the same and applies to both calls and puts

 

  • In the money:  With a call option, the strike price is below the price of the actual stock.  An in the money put option has the strike price above the stock price

 

  • Out of the money:  Where a call option strike price is above the stock price.  An out of the money put option has the strike price below the stock price

 

As you progress and gain experience, these terms will become second nature to you.  The relationship between the stock price and the strike price will determine if there is intrinsic value and only “in the money” options will have intrinsic value.

 

 

WHAT IS A PREMIUM

 

 

This is the money you will pay to the seller of the option.  It is stated as a per share amount and since each contract contains 100 shares of a stock, make the x100 calculation.  If you are trading an in the money contract, expect to pay a higher premium for the contract.

 

 

ALL OPTION TRADE EXAMPLE

 

 

You’ve decided to take your first options trade and have chosen a call option on stock ABC.  Now what?  There are so many strategies to trade options and for this example, let’s keep it basic with a bullish directional play and we will use a strike price of $50.

 

 

Before Expiration, You Can Trade The Contract

 

 

Imagine that after purchasing the contract, the value of ABC has risen to $60/share on good company earnings.  Remember that you have the right, not the obligation, to buy the stock and in this instance, you choose not to.  You exercise your option and pocket, before any fees and commissions, $10/share or $1000 ($10/share x 100 shares).

 

 

Hold To Expiration

 

 

Perhaps you decided you wanted to actually own the ABC stock because you believe that the stock had great earnings and will continue to be a sought after stock.  Given the same scenario as above, you exercise your right to buy at $50/share even though the stock is sitting at $60/share.  The seller of the option has the obligation to sell me the asset at the agreed upon strike price.

 

 

Let It Expire

 

 

It turns out that the good earnings from ABC was simply a calculation error and the stock price has tumbled to $35.  It is worthless to you at this point and you simply let it expire.  Here is why we love options:  The stock can fall to $0 and since my risk was limited to the price of the option, I don’t hold worthless stock like I would if I exercised my right to buy