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:
There are a handful of reasons that may prompt you to explore options further and these are the ones that interested us:
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:
These variables make up an Options contract
|Underlying Asset||Stock ABC|
|Numbers Of Contracts||1( 1=100 Shares )|
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.
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
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.
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.
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.
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).
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.
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