Stock Options Explained
Welcome to the Income Switch Options Mastermind Course.
Here is the course table of contents, which you can navigate, make sure to follow the orders of the lessons.
Lesson 1: An Introduction to Options Trading
I’ve commented about buying options in my personal account to either take advantage of a special situation I see or to hedge a position in my long portfolio. And, a lot of you have asked for more information about my philosophy regarding options trading. Now, I want to give you the same tools I use to make more complex trades, and help you get to a level where you’re comfortable enough to trade them.
The following is a series designed to offer some basic education to help those of you who have an interest in including options as part of your overall investment strategy. But, before we begin, it’s important to know that options are not for everyone. I’ve got to say this as we begin — Options are inherently risky and you could lose 100% of your investment or even more.
Here’s an example:
Let’s say you buy 100 shares of XYZ at $10 a share, expecting it to trade to $12 in the next month (you expect to make $200 profit).
If you’re wrong, and XYZ trades to $9.50, you can sell the stock and limit your loss to 50-cents a share (or $50 in this case). Or, if XYZ is only at $11 at the end of your expected one-month holding period, you still make a $1 per share profit ($100, or 10%, on this trade).
When buying an option however, you might need to be right on the direction, price, time and volatility to make money on a the trade. The price of an option is a function of some of these factors and are not one dimensional like stocks, which are solely dependent on price action.
Let’s say that you buy an XYZ $12 call option (we’ll explain “call option” soon) expiring in 30 days when the underlying stock is trading at $12.
Here’s are some possible outcomes.
If XYZ drops to $9.50, your $12 call option could lose a large portion of it’s value. If XYZ isn’t above $12 on the expiration date, you’ll lose everything it cost you to buy the option. That said, options are wasting assets.
In other words, when you’re buying options you’re playing a game of beat the clock. You’re saying I think the price of the stock will be at this price by this date.
Inexperienced traders and investors might find options difficult to understand, and they could be inherently risky! But, so too is a chef’s knife. However, for a skilled cook, a chef’s knife is an invaluable tool. Likewise, for a trader who knows what he or she is doing, options can be an important part of their investment toolkit.
Here’s a screenshot of an actual trade:
As you can see, trading options can be very lucrative. That’s why, before you go any further with these lessons, I encourage you to download the booklet, Characteristics and Risks of Standardized Options published by the CBOE. Reading that booklet will go a very long way to edifying the lessons I’ll offer you and help cement some of the concepts I’ll teach you.
Now, before you run out and open an options trading account, let’s talk a little about suitability. There are four levels of Option Approval that are imposed on investors by brokerage firms and determine the type of account you can have.
In general, you should only trade options with risk capital — money you can afford to lose. Of course, no one trades to lose money, but trading options is not investing– it’s speculation.
Here are the four levels of Option Approval that your broker will impose on your account
(We have not gone over any strategies in detail yet, so this section is something you might want to go back to after you familiarize with them).
Approval Level One – Allows you to buy cash-secured puts (not bought on margin) and write covered calls. You have to have common stocks already in your account to get this level of approval and the only options you can buy or sell are those of the stocks you already own. And, the number of contracts you can buy or sell is limited to your long position of stock (i.e., if you own 100 shares of XYZ you can only buy 1 XYZ put or sell 1 XYZ call at a time).
Approval Level Two – Gives you Level One ability and allows you to buy any number of puts or calls that you want (as long as you have the cash or margin buying power), including options on stocks, ETFs, or indexes.
Approval Level Three – This one lets you do everything in Level Two and trade spreads. You can enter into a short spread if you have sufficient liquidity (cash or buying power), but you can’t do anything naked (uncovered shorting).
Approval Level Four – This is the granddaddy of all option approval levels. It gives you the ability to do anything you could do in Level Three and allows you to write naked calls and naked puts.
In the next lesson I’ll introduce the basic uses of Puts & Calls – what they are and how they can be used to achieve various investment objectives.
Lesson 2: Options Terminology
Last time we learned about the risks associated with trading options – if you’re not careful, you can lose your entire investment on any given trade. However, options don’t have to be scary. In fact, many strategies allow you to control risk better than equities. Before you get started trading options, you’ll need to understand some of the basic terminology.
Put – The right, but not the obligation to sell the underlying at a specific price by a specific date.
Call – The right, but not the obligation to buy the underlying at a specific price by a specific date.
Contract – The basic unit of an option. For stock options it is the right to buy or sell 100 shares of the underlying security. Buying 1 contract gives you the right to control 100 shares of stock.
Long – To buy, or own, a contract. Also known as holding.
Short – To sell a contract. Also known as writing.
Underlying – The instrument on which the contract is based. It could be a stock, an index, or an ETF. If you buy an option on AAPL stock, then AAPL is considered the “underlying”.
Strike – The price at which an option’s contract gives the holder the right to buy or sell the underlying.
Exercise – This one has two meanings. It’s the same as strike, but it is also the act of making good on an option. For a call, exercise means to buy the underlying. For a put, exercise means to sell the underlying.
Premium – The amount of money it costs (when buying an option) or collecting (when selling an option). For example, if you buy an option for $1.00, the total would be ($1.00 x 100) $100.
Intrinsic Value – This is the inherent value of an option. It’s calculated by subtracting the strike price from the current price of the underlying. An option only has intrinsic value when it is in-the-money.
Extrinsic Value – This is the value of an option over and above its intrinsic value. It’s also known as time value.
In-the-money (ITM) – An option that has intrinsic value.
At-the-money (ATM) – This happens when the strike and the market price of the underlying are the same. At-the-money options consist of time value only.
Out-of-the-money (OTM) – A call is OTM when its strike is higher than the current market value of the underlying. A put is OTM when its strike is lower than the current market value of the underlying. These options only have time value.
Expiration – The date on which the option contract ceases to exist.
The Greeks –They measure the different factors that affect the price of an option. We’ll go over these in further detail as the course progresses.
Holder – The buyer, or owner of an option.
Writer – The seller of an option.
Hedge – A strategy that attempts to protect a position. Think of it like you would as an insurance policy.
Historical Volatility – Measures dispersion of returns around the mean.
Implied Volatility – The market’s “guess” on future volatility. It’s based on supply and demand.
Synthetic – Using options to create the risk/reward profile of a stock position.
Buy / Write – Simultaneously buying a stock and writing a call against it.
Assignment – If an option expires at least one penny in-the-money at expiration, the holder of those options will be assigned 100 shares for every option that they have. The option buyer has the right to take assignment at any time prior to expiration. The option seller can be obligated to assignment at any time.
Front Month – The nearest term (monthly) option contract.
Calendar Spread – Also known as a time spread. An option strategy created by buying and selling two of the same type of option on the same underlying at the same strike price with expiration in two different months.
Class – The set of all of a given type of option; either puts or calls.
Long Vertical Spread – An option strategy created by simultaneously buying and selling a similar option on the same underlying with the same expiration but using different strike prices.
Long Straddle – An option strategy created by buying one at-the-money put and one at-the-money call on the same underlying, expiring in the same month.
Long Strangle – An option strategy created by buying one out-of-the-money put and one out-of-the-money call on the same underlying, expiring in the same month.
Butterfly Spread – An option strategy created by combining two vertical spreads on the same underling. One spread will be long, the other will be short.
Credit – The amount of premium received when selling an option.
Debit – The amount of premium paid when buying an option.
Near-term – An options contract that expires 1 to 3 months out.
Mid-term – An options contract that expires 4 to 6 months out.
Far-term – An options contract that expires 7 to 12 months out.
LEAPS – An options contract that expires further out than one year. The acronym comes from Long-term Equity Anticipation Securities.
In due time you’ll get more familiar with these terms, for now, feel free to come back to them as we go further into the lessons.
Lesson 3: Mechanics of Options
Now that we’ve gone over some basic options terminology, we’re going to move onto the mechanics of options.
Options are binding contracts that give you the right to buy or sell some financial asset. For the remainder of this course, I’m going to focus on stock options, although, as I mentioned earlier, there are other standardized options on indexes, bonds, etc.
There are two types of options: puts and calls. A put gives you the right, but not the obligation, to sell 100 shares of a stock. A call gives you the right, but not the obligation, to buy 100 shares of stock.
There are just three components to an option you really need to focus on: its strike price, its premium, and its expiration.
Strike price is the price at which the contract gives you the right to buy or sell the stock.
Premium is the option’s actual price. An option buyer pays premium. An option writer receives premium.
Expiration is the date when the option cease to exist. Options always a defined lifespan, they die at a certain date. Owning a stock does not, you can own a stock indefinitely… unless it goes out of business!
Here are some examples of these components:
January 50 call selling for $.50.
March 30 put selling for $1.00.
The January 50 call would give you the right to buy 100 shares of the underlying stock at $50.00 per share between now and the date it expires in January. The March 30 put would give you the right to sell 100 shares of the underlying stock at $30 per share between now and the date it expires in March.
“Regular” options expire on the third Friday of the month. But, some stocks do have “weekly” options, which expire every week. But, in general, regular expiration is the third Friday of the month. These also typically have more volume of trading and are more “liquid”, meaning that you can enter and exit them easier.
At expiration, there are only two things that can happen to an option. Either it is assigned into stock, or it vanishes. What this means is that all options either have value at expiration and will get exercised into stock or they will expire worthless.
There are two sides to every options trade. There is the buyer, or holder. And, there is the seller, or writer. To buy an option is to be long the option. To sell an option is to be short the option. The buyer in an options transaction has the right to buy or sell the stock, but the seller is obligated. He has to buy or sell. He doesn’t have an option (no pun intended).
A call buyer is a bull and is looking for the price of the underlying stock to increase in value by expiration. A put holder has the opposite investment opinion. A put buyer is a bear and is looking for the stock to decrease in value by expiration. The flipside is true of sellers, or writers. A call writer is a bear and is looking for the stock to decline. A put writer is a bull and is looking for the stock to rise.
Now, one of the main benefits of options is that you know your risk going into a trade. When you’re long an option you know from the outset what your maximum expected loss is. And, this is a very easy concept. The maximum you can lose on a long option position is the premium you pay for the option. But, this is why some investors think options are risky. Because, said another way, the maximum you can lose on a long option position is 100% of your investment.
In the coming weeks, I’ll talk more about managing and mitigating risk, but for right now, it’s important for you to understand when you are long an option your risk is that you could lose all of the money you have in that specific trade. But, you can’t lose any more than that.
That is not the case when you are short an option. A call writer (who is not otherwise long the actual stock of the underlying) has unlimited risk. In the next lesson, I’ll explain more about selling a call when you’re long stock, but for now let’s focus on selling a call when you aren’t long the stock.
Selling a call option on a stock that you do not own is referred to as writing a naked call. When you write a short call, this obligates you to buy the stock at the price you agreed to. And, remember that a short call is a bet that the stock is going to decline. But, if it doesn’t, then you are obligated to buy the stock at a higher price. I’ll show an example here soon, but let’s wrap this segment up with a quick discussion about selling puts.
Selling a put when you don’t own the underlying stock is referred to as selling a naked put. And, again, the option writer is obligated. In the case of a short put, the seller is obligated to buy the stock at the strike price. The put writer wants the stock to go up. He’s a bull. But, if the trade goes bad, and the stock declines rather than rises, then the seller of a naked put (like the seller of a naked call) has more money at risk than just the premium.
Okay, so this is a good place to look at some examples. In each of them, we’re going to be looking at a $10.00 strike price and a $1.00 premium for both the puts and calls.
Let’s say you think a stock is going to rise in value, so you buy a $10.00 call option. Let’s say that the option premium is $1.00. If the stock does what you think and goes up, then the value of your option is going to increase in value above the $100.00 investment you made (remember, an option gives you the right to buy 100 shares, so buying one option at one dollar equals a one hundred dollar investment). If the stock doesn’t do what you expect and goes down, then your option is going to lose value and could expire worthless. Here’s what that risk/reward scenario looks like graphically.
Now let’s look at the opposite side of this trade.
Now you think the stock is going to decline in value. Here you sell a $10.00 call option. The option premium is still $1.00, but this time you collect that $100.00. If the stock declines and is at or below $10.00 at expiration, then your option is going to expire worthless. But, you get to keep the $100.00. The premium you received is your maximum profit.
But, if the stock rises in value, then you’re in trouble. This is because the stock could go up indefinitely. And, you’re obligated to sell the stock at $10.00. This means that you’re going to sell for ten bucks something that you’re going to have to buy (to cover the short) for a LOT more than $10.00. This is the complete opposite of the concept of buy low/sell high. And, here’s what the risk/reward scenario looks like for this trade.
Buying a put is the opposite of buying a call. Here you’re looking for the stock to decline. If it does, then your option increases in value. If the stock rises, then your put option loses value. Here’s what that looks like on a graph.
Remember that the put seller is a bull. He thinks the stock is going to rise. If it does, the trade is a winner. But, also remember that for an option seller the premium received is the maximum profit that can be made on the trade. In this particular case, the reason is that if the stock does rise, then the obligation to buy it at $10.00 is worthless since nobody would be willing to sell the stock to you at $10.00, when they could go into the open market and sell it for a whole lot more.
The flipside of this trade is that the stock could go lower. If it does, then you (again) are obligated to buy it at $10.00. But, now you’re going to have a flock of willing sellers, since the market is lower than $10.00. So, you risk much more than the $100.00 in premium you received. However, since the stock can’t go any lower than zero, your risk is not unlimited in the way that it is for selling a naked call. And, here’s, what the risk/reward scenario looks for this trade.
Okay, so to wrap all of this up, I put together the following grid to help you visualize the basic differences between puts and calls and being long and short.