1. Options Basics: Introduction
  2. Options Basics: Call and Put Options
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types of Options
  6. Options Basics: How to Read An Options Table
  7. Options Basics: Options Spreads
  8. Options Basics: Options Risks
  9. Options Basics: Conclusion

Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. Remember: “options give you options.”

If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. A call option gives the holder the right to buy stock and a put option gives the holder the right to sell stock.

Call and Put Options

Think of a call option as a down-payment for a future purpose. Let’s look at an example:

A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built. For instance, will there be a school going up soon? Or will there be a garbage dump coming? These circumstances would affect their decision to buy the home. The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can – you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.

With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. No garbage dump is coming nearby. The home buyer exercises the option and buys the home for $400,000, because that is the contract purchased. The market value of that home may have doubled to $800,000. But because the down payment locked in a pre-determined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.

Take a look at the example below – it’s an excerpt from my Options for Beginners course introducing the concept of call options:

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.

What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years. If in six months the market crashes by 20% (500 points on the index), he/she has made 250 points by being able to sell the index at $2250 when it is trading at $2000 – a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (its premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.

See below another excerpt from my Options for Beginners course where I introduce the concept of put options:

 

These examples demonstrate some very important points:

First, when you buy an option, you have a right but not an obligation to do something with it. For stocks and many options on futures, it’s not required to exercise your right to buy or sell stock by expiration. However, if your option has value at expiration, in general, your broker will automatically exercise the option. In our put example above, if the S&P 500 fell to zero at expiration, the 2250 put is worth 2250. At expiration your put option would settle for the cash value, causing a large gain on the hedge. Keep in mind that stocks are physically settled. Now, back to our put example: if the S&P 500 went up to 3000 at expiration, your 2250 put is worthless. 

Second, the most you can lose when buying an option contract is the premium spent. This is an attractive trait for many. Limited risk allows option buyers to sleep at night.

Third, an option is a contract on an underlying asset. Its price is derived from the underlying asset’s price. That’s why options are derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but as mentioned, options are actively traded on all sorts of financial securities, such as bonds, foreign currencies, commodities, and yes, even other derivatives!

Buying and Selling Calls and Puts: Four Cardinal Coordinates

Buying a stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.

Buying a put option gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial: they relate to the four things you can do with options: buy calls; sell calls; buy puts; and sell puts.

People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between holders and writers:

  • Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more, and in some cases unlimited, risks. This means writers can lose much more than the price of the options premium.

Don't worry if this seems confusing – the important thing to know that there are these 4 fundamental scenarios to be aware of.

Options Terminology

To really understand options, you need to know the options market terminology.

The strike price of an option contract is the price at which an underlying stock can be bought or sold. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. This must occur on or before the expiration date in order to be in-the-money. In our example above, the strike price for the S&P 500 put option was 2250. The index had to fall below 2250 on or before expiration to be exercised for a profit.

The expiration date, or expiry, of an option is the precise date that the option contract terminates.

listed option is an option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE). Listed options have fixed strike prices and expiration dates. Each listed option represents 100 shares of stock (known as 1 contract).

For call options, the option is in-the-money if the share price is above the strike price. For example:

ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money.

A put option is in-the-money when the share price is below the strike price. For example:

ABC April 50 Put. ABC stock is trading at $45. The Put is $5 in-the-money.

 

The amount by which an option is in-the-money is also referred to as its intrinsic value. For example:

ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money and also has $5 of intrinsic value.

An option is out-of-the-money if the price of the underlying remains below the strike price (for a call), or above the strike price (for a put). An option is at-the-money when the price of the underlying is at or very close to the strike price. For example:

ABC April 50 Call. ABC stock is trading at $45. The Call is out-of-the-money and also has no intrinsic value.

ABC April 50 Put. ABC stock is trading at $55. The Put is out-of-the-money and also has no intrinsic value.

ABC April 50 Call. ABC stock is trading at $50. The Call is at-the-money and also has no intrinsic value.

ABC April 50 Put. ABC stock is trading at $50. The Put is at-the-money and also has no intrinsic value.

Remember, the total cost (the price) of an option contract is called the premium. This price is determined by a few factors, including:

  • stock price
  • strike price
  • time remaining until expiration (time value)
  • volatility

Although employee stock options aren't available for everyone to trade, they are still a type of call option. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The employee stock option contract, however, exists only between the holder and the company. It typically cannot be exchanged with anybody else. A listed option however, is a contract between two parties that is completely unrelated to the company and can be traded freely.


Options Basics: Why Use Options?
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