What are options?

Raining Money

Options are financial contracts that give the buyer the right and not the obligation to buy or sell a stock at a specific price by a certain date.

The seller has the obligation to buy or sell the stock at that specific price if the buyer wants to at that specific price.

This all sounds very formal and I am sure that definition is a modified version of something I read in the past. 

This is a pretty straightforward concept or at least it’s supposed to be straight forward but anytime I’ve read about it, it’s just complicated. Options are flexible and people use it for different purposes and I think trying to explain all of that makes it complex for anyone let alone a beginner. The flexibility that comes with options makes it a very vast topic and jumping into them with a lot of money in the beginning can quickly spiral out of control leading you to lose all of your money. Here, I will try to explain the very basics (just scratching the surface) of options but before we get into them, there are a few terms that you have to know.

  1. Strike price

It’s a contract so two people have to agree on what price the shares are going to be bought or sold. That’s the strike price.

  1. Expiration

This contract is only valid for a certain amount of time. That’s the expiration date. Another way to think about it is like your car insurance where you pay your premium for 6 months and you get coverage for those six months. Once those six months are over and if you don’t pay again then you don’t have insurance. Your coverage is over. your contract has expired.

Popular stocks that trade very often and are household names have contracts that expire every Friday for the most part and the rest of them have one expiration each month which is on the third Friday of every month.

  1. Premium

Using the car insurance example, you pay a premium to have the insurance. Similar to that, a buyer has to pay a premium to have the opportunity to buy or sell the stock at the strike price. This applies to anyone buying an option.

  1. Collateral

if you get into a car accident your insurance company covers the cost because of the insurance contract you have. The money that is set aside by insurance companies to pay for those damages is the collateral. Depending on the kind of option, the collateral can be money or stock. This applies to anyone selling an option. It is also called buying power reduction if you are using a margin account.

  1. Option size

This is not a definition per se. This is more of a need to know. Each option contact is for 100 shares. 

There are two types of options

  1. Call
  2. Put

There are two parties involved

  1. Buyer
  2. Seller

Combining all of these different variables seems very daunting but those give you the flexibility of making a directional bet easily. 

As a beginner to options this is how I look at it. The risk is different depending on what combination you go with.

If you think a stock will go up then you can either buy a call or sell a put. The amount of money you can make will be vastly different and the way you would set up the options contract would be different. Buying a call would cost you very little upfront and the amount you can make from is astronomical if the stock skyrockets. Selling a put would require you to keep a significant chunk of money as collateral and the maximum profit would be whatever you collected initially as premium when you sold the put option.

So how does this work and what would it look like

Buying call options

XYZ company is trading at $50 a share right now and you think the stock is going to move up to $70 a share in two weeks. 

You might consider buying the $60 strike call option that expires a month away for $1.00. This will cost you $100 because each option contract is for 100 shares. This is the premium.

If your assumption comes true then you stand to make $9 per share ($900 because a contract is 100 shares) 

The calculation works out to be $70 per share which is the stock price at expiration minus $60 per share which is your strike price and then minus the $1 per share you paid in premium.

This would be a 900% return because you made $900 using $100. The same move in the stock will get you a return of 40% where you would make $2,000 in profits on the initial $5,000 spent to buy the stock.

$70 – $60 – $1 = $9 

Stock price at expiration – Strike price – Premium Paid = Profit

This is great when everything works out the way you want but what if the stock price stays at 50 and does not move at all then the call would expire worthless and you would lose the $100 you paid initially as premium.

When and why would you do this?

  • Amplified returns.
  • You are convinced the stock will move up dramatically in a certain time frame. Especially handy for small biotech companies that sees a big stock price jump after getting FDA approval.
  • You are willing to lose the premium if the stock move you are hoping for doesn’t pan out.
  • More Misses than hits.
  • YOLO move – you only live once or you really lose once depending on how you look at it.

Selling put options

All the assumptions for XYZ company stays the same, XYZ company is trading at $50 a share and you think it will go up to $70 in two weeks

You might consider selling the $30 Strike put option for a month out for $1.00 ($100 since the contract represents 100 shares). This will cost you $3000 in collateral.

If they stock moves up to $70 a share in a month then the contract expires worthless and you will keep the $100 in premium you collected. Well as long as the stock price stays above the $30 strike price at expiration, you will keep the $100 collected initially.

If the stock is below the $30 then you will have to buy the stock at $30 a share since that is the contract you agreed to. This is where the $3000 collateral comes into play. You have already set this money aside when you started this trade.

The calculation works out differently from buying a call, you already know the maximum you can make is $100 as long as the stock price is above $30 a share at expiration.

Your return would be $100 on $3,000 you put down as collateral. This would be 3.33% in one month

When and why would you do this?

  • Consistent returns.
  • It’s a stock you like but you want to buy it at a lower price.
  • You think the stock will move but you are not fully convinced of it.
  • You want to get paid while waiting for the stock to come to a lower price.
  • More hits than misses.
  • Generate an income-based investing or trading.

Now moving to the other side, the scenarios are going to sound very repetitive since it’s just the other side of the same coin.

If you think a stock will go down then you can either buy a put or sell a call. Everything in this portion works in reverse of the items mentioned above. Buying a put will cost you very little upfront and the amount you can make from it is significant if the stock tanks. A key difference here compared to buying a call is that there is a limit to how much you can make because the worst that can happen to a stock is for it to go to $0. Similarly to selling a put, selling a call would require you to keep a significant chunk of money as collateral or 100 shares of the stock and the maximum profit would be whatever you collected initially as premium when you sold the call option.

Buying put options

Buying a put resembles the car insurance analogy I gave earlier except you are hoping for an accident to happen. Pay the premium and get a big payout if things go horribly wrong with the stock. But a less cynical way to look at it is buying a put option to protect stock you already own and in this way the put will behave exactly as having car insurance where you pay your premium just in case something bad happens.

Using the same XYZ company as the example, XYZ company is trading at $50 a share right now and you think it’s going to come down to $30 in two weeks. You can buy a put at a strike price of $40 spending $1 in premium which would be $100 because each contract is one under chairs.

Similar to buying a call, if everything works out you would net $900 profit after spending $100 in premium.

The calculation works out to be $40 per share which is the strike price minus $30 per share which is your stock price at expiration and then minus the $1 per share you paid in premium.

This would be a 900% return because you made $900 using $100.

$40 – $30 – $1 = $9 

Strike price – Stock price at expiration – Premium Paid = Profit

When and why would you do this?

  • Amplified returns.
  • You are convinced the stock will move down dramatically in a certain time frame.
  • A cheap way to protect stock you already own.
  • You are willing to lose the premium if the stock move you are hoping for doesn’t pan out.
  • More Misses than hits.

Selling call options

We are back to XYZ company and it’s trading at $50 a share and you think it will go down to $30 in two weeks.

You might consider selling the $70 Strike call option for a month out for $1.00 ($100 since the contract represents 100 shares). This collateral is a bit iffy, you can put 100 shares as collateral or it would be an amount that is calculated by your broker if you have a margin account.

If the stock moves down to $30 a share or stays below the $70 strike price in a month then the contract expires worthless and you will keep the $100 in premium you collected.

If it doesn’t work out then you sell the shares at the agreed strike price.

When and why would you do this?

  • Consistent returns.
  • Make money on the stocks you already own.

Conclusion

Options are risky but the first step is to understand what options are so you can understand the risks associated with them. Buying options is the easy part where you could potentially make a lot of money but the trade off is you will have more losers than winners. Selling options gives you a cap on maximum returns and statistically have more winners than losers.