What are Stock Options?

So you want to get into trading options, but don’t know where to start? That’s okay, because learning options is like learning anything else: You just need practice. That’s not to say options trading isn’t hard, because some of the methods can be quite complex. We’ll get into some of that later, but for now, let’s stick to the basics.

The first step to options trading is having experience in either trading or investing. Sounds anticlimactic, I know, but trading options is a tool that should be added to your arsenal of investing or trading strategies; not the starting point. In other words, you wouldn’t learn how to be a professional race car driver without first getting your license.

Let’s go with the assumption that you do have experience in either trading or investing and are simply looking to widen your knowledge of the financial markets.

So what exactly is an option? It’s called an options contract for a reason, and that’s because the buyer and seller are actually entering into an agreement where one party (the buyer) has the right to X amount of shares at X price on X date. The other party (the seller) has the obligation to deliver that predetermined amount of shares at a specific price on a specific date.

One standard options contract is good for 100 shares. The agreed upon price is referred to as the ?strike price? and the date is referred to as the ?expiration date.?

In its most basic form, investors are faced with two options – no pun intended – when trading options: to buy calls or buy puts.

For all intents and purposes, if you believe shares of ABC are going higher, you would buy call options, and if you believe shares of ABC are going lower, you would buy put options.

Seems simple enough, right? If only it were that easy.

Now if you’re starting to feel overwhelmed, that’s okay. Everyone’s a little apprehensive their first time, but as with most things in life, it gets much easier after some experience.

How Do Call Options Work?

Let’s start with an example and go from there. Let’s say we’re really bullish on shares of ABC and we think the stock is going much higher. Currently, ABC is trading at $62 and its February 21st. We want to be long ABC, but don’t want to commit $6,200 in order to buy 100 shares because of other macro-related risks, like a broad market selloff.

Instead, we look at the options chain, which displays all of the options available for ABC, along with strike prices and expirations.

We’ll have to chose a time period, or how long we’ll want to own the option. Some expire in as little as a week, while others expire in a few years, which are referred to as LEAPS (Long-term Equity AnticiPation Securities). For our situation, we just want the option for a few months, so let’s pick the April monthly expiration*. That will give us roughly two months for our play to pan out.

*Standard monthly options expire following the third Friday of each month.

Finally, we’ll have to choose a strike price, which is the level we’ll have the right to purchase the stock come expiration day. With the stock at $62, any call option strike price below that level is considered ?in-the-money? or ITM, and any strike price above that level is considered ?out-of-the-money? or OTM. And as you may have guessed, the strike price nearest the stock price is considered ?at-the-money? or ATM.

Generally speaking, the deeper in-the-money the option is, the more it will cost. That’s because option prices are made up of a few things, time value and intrinsic value being two of them.

Intrinsic value measures how much the option is worth right now, as if it were to expire today. Time value is how much extra premium is priced into the option. Eventually, the time value will drop to zero at or near expiration.

In our example, with ABC trading near $62, we know that the $60 strike call option has an intrinsic value of $2.00 per share, because if it were to expire today, the option is already $2.00 per share in-the-money.

However, if the option still has several months until expiration, it’s likely that the $60 option could trade for around $4.25 – meaning $2.00 of the option is composed of intrinsic value and the rest, or $2.25 in this case, is composed of time value.

Likewise, a stock that’s out-of-the-money trades with no intrinsic value and all time value. For instance, in our example with ABC at $62, the $65 strike call option costs $2.00. Since the call option is out-of-the-money, it would be worthless if expiration were today. So the entire cost of the $2.00 option is all time value.

Options pricing is not an easy science – in fact, it’s quite complex. That’s why so many people struggle to understand these instruments.

So let’s focus exclusively on our example to make sense of it all. Remember, we’re bullish on ABC, which is trading at $62 in late-February. To play an upside move over the next two months, we’re going to purchase one $65 strike call option for $2.00 that expires in April.

Rather than risking $6,200 to buy 100 shares of the stock, we’re risking $200 on the call option instead.

While the $65 strike option may have no intrinsic value at the moment, and the time value will decay over time, it will be a slow process, and the option will still gain in value should shares of ABC rise significantly over the next 6-8 weeks like we believe it will do.

Our break-even on the trade is $67, which is the strike price plus the premium we paid for the call option, ($65 strike price + $2.00 premium = $67 break-even).

Shares of ABC begin climbing and when we finally get to April expiration, the stock is trading at $70 per share. The time value of our option will have dropped to $0, but the intrinsic value is worth $5.00, ($70 current stock price – $65 strike price = $5.00 per share). This also represents our gross profit – but remember to multiply the outcome by 100, for each share in the option contract.

To calculate our net gain, we have to subtract the cost of the option, which was $2.00 ($200), from our gross profit of $5.00 ($500).

$5.00 – $2.00 = $3.00 ($300) net profit.

In this case, we risked $200 and generated a net profit of $300, good for a 150% return.

Do We Want to Exercise?

Come expiration day, investors are forced to choose between two options – again, no pun intended. We’ll either need to sell the call option, realizing our $300 gain, or we’ll need to exercise the option, which will ?call? away the stock from the seller at $65. Assuming we exercise the stock, we’ll pay out $65 for each share in the contract, or $6,500 total.

Remember though, our cost basis will actually be $67 per share, because we paid $2.00 per share for the options contract. You may notice that the $3.00 per share difference in your cost basis when exercising and the stock’s current price of $70 also represents a $300 gain, the same gain we would have by simply selling the option.

To exercise or not to exercise? In my personal experience – and generally in most traders’ experience – exercising is a rare event. You typically wouldn’t exercise your rights to the stock, unless you truly wanted to own the stock at that level.

Because the profit on the day of expiration is the same, most traders opt to book their gains and move on.

This is where right vs. obligation comes into play. As the buyer of the call option, you have the right to exercise the call option. In fact, you can exercise any day that you want prior to expiration day, assuming you’re trading U.S. equity options. This type of exercise is called American style, whereas European style only allows the buyer to exercise their options on expiration day.

While the buyer has the right to exercise whenever they chose, the seller of the option has no choice. Instead, they have the obligation to fulfill their end of the bargain, and provide 100 shares per contract at the predetermined price, should the buyer chose to exercise.

Keep in mind that either the buyer or the seller can close their position at any time prior to expiration as well. If the stock has rallied and the call buyer wants to book their gains early, they can do so by simply selling their call option. If the seller of the call option feels like they’re losing too much, they can cut their losses and close their position as well, (more on selling options later).

Also keep in mind that should your option close in-the-money by $0.01 or more, your option will be automatically exercised if you hold it through expiration.

Just remember: The buyer has the right, the seller has the obligation.

What About Put Options

Put options work the same way call options do – only in the opposite direction. Just like call options give the buyer the right to purchase stock at a certain price, put options allow the buyer the right to sell the stock at a certain price.

Again, let’s take ABC as our example. The stock is trading near $62 in late-February and we’ve grown quite bearish on the company’s prospects over the next few months. Rather than having unlimited risk to the upside by shorting the stock, we instead look to buy put options.

Put options, for the purpose of this discussion, gain in value when the underlying stock declines.

When looking for call options, strike prices below the current stock price are considering ITM, whereas with put options, strike prices above the current stock price are considered ITM. This is because if we were to exercise the put option today, it would give us a short position in the stock above today’s current share price, meaning the option holds intrinsic value.

Now that our hypothesis concludes shares of ABC are headed lower, we’ll need to pick a strike price and an expiration date. For this example, let’s say the April expiration $60 put option is trading for $2.50.

Our break-even on the stock for this trade is $57.50, which is the strike price, along with the premium for the put option. ($60 – $2.50 = $57.50).

A few weeks go by and ABC reports disappointing earnings alongside a pessimistic economic backdrop for the broader economy. Shares tumble lower and come expiration day in April, the stock is trading at $52. What’s our gross profit? What’s our net profit?

Remember, to find the gross profit we simply subtract the stock’s current price, $52 in this case, from the strike price of $60. $60 – $52 = $8.00, ($800).

To find our net profit, we have to subtract our cost of the option from the total gain, so it’s $8.00 – $2.50 = $5.50 ($550). Our tidy profit of $550 represents a 220% return in value, despite the underlying stock falling just 16%.

Just like with the call option, the most we risk by purchasing the put option is our premium, in this case $2.50 ($250). In the event of a stock rally, our put option will expire worthless if the stock closes above $60 on expiration. While losing $250 is never fun, we can always chose to cut our losses after a predetermined decline, say of 50%, so we’ll only lose $125.

Even a full lose of $250 is much better than the potential outcome of a rally when short 100 shares. If ABC were to climb to $70 and we were short 100 shares at $62, our losses would be $800, much more than the $250 we risked on the put option.

The bad thing about buying options is that you can lose 100% of your investment, meaning the option can expire worthless if it doesn’t move in your desired direction. On the flip side though, the amount of capital required for buying one call or put option is usually a fraction of the cost of buying or shorting 100 shares of that same security. Plus, you know your maximum downside right off the bat.

In the next article, we’ll look at how to generate extra income in sideways to slightly down markets, how to get paid to buy a stock at a cheaper price than it’s trading at today, and what the difference is between the ?bid? and the ?ask.?

A Little Recap

Call Option – When bought, buyer agrees to purchase 100 shares of stock at a predetermined price.

Put Option – When bought, buyer agrees to sell 100 shares of stock at a predetermined price.

Strike price – The exercise price of the stock option.

Expiration Date – The day in which the option expires; available in weekly, monthly, quarterly and LEAPS expirations. Monthly options expire following the third Friday of each month.