What Are Options & How Do They Work?
An option is a standardized contract that allows you to buy and sell a certain amount (typically 100 units) of an underlying stock at a specific price for a specific time.
Ok, there’s a difference between stock ‘shares’ and stock ‘options’. With shares you get to own a piece or percentage of the company. As long as you own it, you have a “share” in the company, like any shareholder or owner.
With options, you get a contract and like all contracts, there are two parties involved — a buyer and a seller. The underlying agreement is attached to a specific company’s shares. Each contract let’s you control 100 shares. The value of the contract varies… that’s what we call the option price. This is what accelerates your returns, because you’re not controlling just 1 share, but 100 shares — there’s the ‘leverage’ we were talking about. When the share’s price moves 1%, the option’s price can have a move of 10%.
A stock option is basically an agreement or ‘contract’ where one party agrees to deliver something (in this case stock ‘shares’) to another person within a specific period of time, for a specific price. So what we’re doing when we trade options, is basically trade these stock option ‘contracts’.
How do they work?
Let’s take an example of how this works. Remember, all we’re going to talk about is buying and selling contracts — because you got options, baby! (Sorry, that was bad humor).
Imagine you’re a real estate investor (a buyer), and you’ve found a nice house that is worth $75,000. You approach the seller, strike a deal with him and enter into an agreement with him by signing a contract… to buy the house within the next 3 years (because you don’t have the cash right now) at $75,000 — no matter what the price could be in the future (the price could go up, but it could also go down). In short, you get a ‘hold’ on the house.
In order to enter this agreement (contract) — you’ll have to make a down deposit that’s not refundable but can be set off against the price when you purchase the house. Some call this earnest money — let’s say $5,000 as good faith deposit (premium).
There could be many reasons why the seller would agree, but let’s just say for now… he’s not sure whether he will get more than $75,000 within the next 3 years. So he agrees. (He could be thinking that the market is going to crash or he may not have any more buyers as he’s rejected quite a few already, whatever the reason). In anycase, he’s going to get the good faith deposit, in addition to the price of the house — whether or not it sells.
Fast forward one year, a shopping mall and a school come up nearby — suddenly the price of the house is now worth $100,000. Remember, you have a contract that allows you to buy that house for $75,000 cash, even though it’s worth $100,000. That’s a good 25% discount if you exercise that contract. Think, just for a second…
You could sell that house the very next day of your purchase, for $100,000 and book a profit! But you would need to cough up $75,000 cash to buy the house. That along with the original down payment you made, means you would require $80,000. But you’d make a return of 20% ($100K / $80K) — not bad eh.
(If you’re really wiley, you could just sign a new agreement with another person take $100,000 from him and make the payment to the original seller and pocket $25,000. But this is a bit more riskier because asking prices are different from actual selling prices in the real world and requires more effort and time… in either case, the contract was your leverage.)
You could do something even better. Just sell the contract you wrote up for $10,000 to someone else (remember you put down a good faith deposit of $5,000) — that’s a 100% return on your money ($10,000 / $5,000).
Why would someone else buy that contract only? Well, he sees there’s another two years left in the contract and he believes the prices could go up again soon — he’s happy to buy, because there’s more potential value in it for him! This is in essence options trading… we sold the contract for a better return on our money. The contract (which allows you to have a ‘hold’ on the house) is your ‘leverage’.
Think for a second which is easier — the drama and paper work of transferring a house or just sending the paper contract! The value is not so much in the house, but the contract — because of the potential value it holds in two years.
So instead of risking $80,000 to make $100,000 (buying and selling shares) — you’re willing to risk $5,000 to make $10,000 (buying and selling options). Greater the profits, minus the drama and hassle. It’s the same game, played on a different level. So rather than buy the house (stock) outright, you can choose to buy contracts (options) on it instead — and that too far cheaper!
Basic Option Trading Terminology
Ok, now that you understand… how options work and why trade them i.e. basically buying and selling contracts that give you the certain ‘rights’, let’s dive in. There are basically two types of options:
- Put Options (simply called ‘puts’)
- Call Options (simply called ‘calls’)
A PUT option (contract) is used to protect the value of your assets, as well as make money when a stock falls in price. A PUT option gives you the right to sell100 shares at a fixed (strike) price. Technically, a PUT option gives the buyer the right, but not the obligation, to sell shares of a stock at a specified price on or before a future date.
So let’s rewind a bit here… something for you to read, repeat and remember:
A put option will increase in value when the underlying stock it’s attached to falls in price, and it decreases in value when the underlying stock it’s attached to goes rises in price.
Have you got your head around that? No, read that sentence again. Counterintuitive maybe, but that’s the essence of it. Imagine you owned a stock and the current market price was for $30 (when you bought it for $40) — would you love to have an agreement that says you could sell it for $50? Bet you would… that’s what a put option is.
A CALL option (contract) is used to make a multiple of your money, when a stock rises in price. A CALL option gives you the right to buy 100 shares at a fixed (strike) price. Technically, a CALL option gives the buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a future date.
Remember that options are for a specific price i.e. the strike (exercise) price and for a specific period i.e the future (expiration) date. When we say we “exercise” the option, we’re basically referring to the contract owner acting upon the agreement.
There are five components of an option contract:
- Underlying Security — options are based on an underlying security — in this case the stock of a company that is listed on an exchange. So if the price of a stock rises and falls, the price of the option will do the same — there’s a direct relationship. This is where we get the term ‘derivative’ from because options are derived from an underlying stock. Keep in mind however, that not all stocks have options because of their low price or lack of volume and not all derivatives are stocks because derivatives can be for stocks or exchange traded funds (‘ETF’s) for precious metals, currency or the index.
- Right, Not Obligation — when you own the option (contract) you will get the right, but not the obligation, to buy or sell the underlying stock at a specified price on or before a future date.
- Price: Specified (Strike) Price — there are various strike prices for a stock option, giving you plenty of choices. Fortunately, this has been standardized — so you won’t see every cent being listed. You’ll probably see prices in increments of $0.50, $1.00 or $5.00.
- Time: Specified (Expiry) Date — whatever right you receive from owning the option — will expire on a given date, in the future. This is basically the life of the option, and after that future given date, the option ceases to exist even when the stock continues to. In technical terms, we explain this with the financial phrase, ‘Time Value of Money’ and with the passage of time as you come closer to the expiry date, the option value decays — we call this time decay. The more time you have to expiry, generally, the more expensive the option will be. And as time goes by, the option value starts to go down. This is unlike stocks, which do not have an expiry — you can own them for as long as you like, without worrying about a decline in value because of the expiry.
- Option (Premium) Price — this is basically the price of the option contract and listed in the “Bid”, “Ask”, and “Last Price” with your brokerage.
What are the four main factors that affect an option?
- Current Market Price — This is the current price of the stock quoted on the exchange every day. As the current market price changes, the option price adjusts automatically.
- Strike Price — This is the actual price at which the option will be exercised (assigned) upon expiry.
- Volatility — This is a critical part of the option contract, some stocks are more volatile than others.
- Time Remaining (Expiry) — The longer the time frame, the more expensive the option contract — because that gives the stock more time to play out its direction. Time can be both an advantage or disadvantage for the trader and investor (if you’re a seller, time can be your friend but if you’re a buyer, time can be your foe). You’ve probably heard of ‘Time Value of Money’ which simply means Time = Money!
Who are the main option market players?
There are basically four types of participants — 1) Call Buyers, 2) Call Sellers, 3) Put Buyers and 4) Put Sellers. Those who buy options are referred to as Option Holders (Owners) with a ‘long’ position and those sell the options are referred to as Option Writers with a ‘short’ position. Don’t worry about ‘long’ and ‘short’ — they are terms hardly anyone uses anymore (it’s confusing anyways).
The following table is worth a second and third glance, it summarizes everything you need to know (of course, as always all options are at a certain price and certain date):
Take note of the right vs. obligation? Ok, then. Just remember that call options are the opposite of put options — that’s all.