The information in this guide is intended to get you started with your understanding of options, the terminology, and their basic characteristics. In addition to this guide, it is recommended that you study all information available under the education section of your broker’s website. Most brokers who cater to options traders provide good information that will help you learn.
Types of Options:
Call Options:
Call options increase in value when the underlying stock rises.
Buyers of calls have the right, without any obligation, to buy the underlying stock at the strike of the options contract. They retain their right until the option no longer exists, defined by the expiration date.
Call buyers anticipate the value of the underlying stock will rise. When it does, the value of the option will also increase at approximately the rate of the Delta. Buyers pay for the right to buy the stock in the future, sometime before expiration of the option. When buying the option, they pay the ask price. The premium they pay is less than buying the stock, yet they will still benefit from any appreciation in the value of the stock.
Call Options – The Sellers…
Sellers of call options are selling to someone else the right to buy the underlying stock from them. When/if the buyer chooses to buy the stock from the seller, (remember, the buyer has no obligation to do so) it is referred to as an exercise…the buyer is exercising the right to buy the stock. The seller is obligated to deliver the stock to the buyer. A seller’s obligation ends when the stock is exercised, the option expires, or the option is bought to close (BTC).
Call sellers receive a premium from the buyer. The buyer is paying the seller for the right to buy the stock in the future. Sellers want the price of the stock to go down. Why? If the price goes down, the buyer will have no reason to exercise since they could buy the stock for less at the current market price. In this case, the seller gets to keep the premium paid by the buyer.
So, what does this mean in plain English? The concept of a call option is present in many situations. For example, you discover a painting that you would love to purchase. Unfortunately, you will not have the cash to buy it for another two months. You talk to the owner and negotiate a deal that gives you an option to buy the painting in two months for a price of $1,000. The owner agrees, and you pay the owner a premium of $50 for the right to buy the painting.
Consider two possible scenarios that can impact the value of this “option”:
Scenario 1: It is discovered that the back of the painting has a signature of a famous artist, which drives the value of the painting up to $10,000. Because the owner sold you an option which gives you the right but no obligation to purchase the painting at the previously agreed price, he is obligated to sell the painting to you, the buyer, for $1,000. The buyer would make a profit of $8,950 ($10,000 value – $1,000 purchase price – $50 for the cost of the option).
Scenario 2: After closer review of the painting, it is discovered that the signature on the back is not of a famous artist, but is the brother of a famous artist. This actually drives the value of the painting down to $500. If the buyer exercised their option to purchase the painting it would cost $1,000. This would not make sense because the buyer could instead just buy it at “market price” for just $500. Since the buyer had no obligation to purchase based on the option contract, the agreement, or contract, would just expire and the buyer would lose the $50 premium paid.
The example demonstrates two important points. When you buy an option, you have a right, but not an obligation, to do something. You can always let the expiration date pass, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you paid for the option.
Put Options
Put options increase in value when the underlying stock decreases in value.
Buyers of puts have the right, without any obligation, to “put” the underlying stock to someone else at the strike price of the options contract. They retain their right until they sell to close (STC) the option or it no longer exists, defined by the expiration date.
Put buyers anticipate the value of the underlying stock will go down. When it does, the value of the option will increase at approximately the rate of the Delta. Buyers pay a premium for the right to be able to put (sell) the stock to someone else in the future, sometime before expiration of the option. When buying the option, they pay the ask price.
Put Options – The Sellers…
Sellers of put options are selling to someone else the right to sell/put the underlying stock to them. When/if the buyer chooses to put their stock to the seller, this is referred to as being assigned……the buyer of the put option is assigning the stock to the seller. The seller is obligated to buy the stock based on the strike price of the contract. A seller’s obligation ends when the option expires or the option is bought to close (BTC).
Put sellers receive a premium from the buyer. The buyer is paying the seller for the right to sell the stock to the seller in the future. Put sellers want the price of the stock to go up. Why? If the price goes up, the buyer will have no reason to assign the stock since they could sell the stock for more at the current market price. In this case, the seller gets to keep the premium paid by the buyer.
Exercise and Assignment
Most stocks and ETF’s are American style options. This means that if the buyer of an option chooses to exercise or assign their rights they may do so at any time prior to expiration.
Indexes such at
SPX
,
NDQ
and
RUT
are European style options. This means that any exercise or assignment may only occur at expiration.
Who wins when the stock moves?
1. Buyers of Calls – win when the stock goes up
2. Sellers of Calls – win when the stock goes down
3. Buyers of Puts – win when the stock goes down
4. Sellers of Puts – win when the stock goes up
Are you new to options trading? Stay tuned for Part 3 of Trader's Guide to Options which will include in-the-money, at-the-money, and out-of-the-money options as well as the reality of trading.
Types of Options:
Call Options:
Call options increase in value when the underlying stock rises.
Buyers of calls have the right, without any obligation, to buy the underlying stock at the strike of the options contract. They retain their right until the option no longer exists, defined by the expiration date.
Call buyers anticipate the value of the underlying stock will rise. When it does, the value of the option will also increase at approximately the rate of the Delta. Buyers pay for the right to buy the stock in the future, sometime before expiration of the option. When buying the option, they pay the ask price. The premium they pay is less than buying the stock, yet they will still benefit from any appreciation in the value of the stock.
- Say you wanted to buy XYZ stock because you think it is going to move up from its current price of $84. Instead of buying the stock a trader could buy a call option for a fraction of the price of the stock. Remember, all the trader is doing is buying the right to buy the stock without any obligation to actually buy it. The option only costs $4.00 for the right to buy the stock at some future date. Buying 1,000 shares of the stock would require $84,000 but buying 10 options contracts would only cost $4,000.
Call Options – The Sellers…
Sellers of call options are selling to someone else the right to buy the underlying stock from them. When/if the buyer chooses to buy the stock from the seller, (remember, the buyer has no obligation to do so) it is referred to as an exercise…the buyer is exercising the right to buy the stock. The seller is obligated to deliver the stock to the buyer. A seller’s obligation ends when the stock is exercised, the option expires, or the option is bought to close (BTC).
Call sellers receive a premium from the buyer. The buyer is paying the seller for the right to buy the stock in the future. Sellers want the price of the stock to go down. Why? If the price goes down, the buyer will have no reason to exercise since they could buy the stock for less at the current market price. In this case, the seller gets to keep the premium paid by the buyer.
So, what does this mean in plain English? The concept of a call option is present in many situations. For example, you discover a painting that you would love to purchase. Unfortunately, you will not have the cash to buy it for another two months. You talk to the owner and negotiate a deal that gives you an option to buy the painting in two months for a price of $1,000. The owner agrees, and you pay the owner a premium of $50 for the right to buy the painting.
Consider two possible scenarios that can impact the value of this “option”:
Scenario 1: It is discovered that the back of the painting has a signature of a famous artist, which drives the value of the painting up to $10,000. Because the owner sold you an option which gives you the right but no obligation to purchase the painting at the previously agreed price, he is obligated to sell the painting to you, the buyer, for $1,000. The buyer would make a profit of $8,950 ($10,000 value – $1,000 purchase price – $50 for the cost of the option).
Scenario 2: After closer review of the painting, it is discovered that the signature on the back is not of a famous artist, but is the brother of a famous artist. This actually drives the value of the painting down to $500. If the buyer exercised their option to purchase the painting it would cost $1,000. This would not make sense because the buyer could instead just buy it at “market price” for just $500. Since the buyer had no obligation to purchase based on the option contract, the agreement, or contract, would just expire and the buyer would lose the $50 premium paid.
The example demonstrates two important points. When you buy an option, you have a right, but not an obligation, to do something. You can always let the expiration date pass, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you paid for the option.
Put Options
Put options increase in value when the underlying stock decreases in value.
Buyers of puts have the right, without any obligation, to “put” the underlying stock to someone else at the strike price of the options contract. They retain their right until they sell to close (STC) the option or it no longer exists, defined by the expiration date.
Put buyers anticipate the value of the underlying stock will go down. When it does, the value of the option will increase at approximately the rate of the Delta. Buyers pay a premium for the right to be able to put (sell) the stock to someone else in the future, sometime before expiration of the option. When buying the option, they pay the ask price.
- Say you thought XYZ stock is going to move down from its current price of $84. Buying a put with a strike of $85 gives the buyer the right in the future to sell or put the stock to someone else at $85. So, if the stock declined to $75, the buyer of the option could buy the stock at $75 and immediately exercise their right to sell/put the stock at $85, making a $10 profit. Remember, all the trader is doing is buying the right but has no obligation.
Put Options – The Sellers…
Sellers of put options are selling to someone else the right to sell/put the underlying stock to them. When/if the buyer chooses to put their stock to the seller, this is referred to as being assigned……the buyer of the put option is assigning the stock to the seller. The seller is obligated to buy the stock based on the strike price of the contract. A seller’s obligation ends when the option expires or the option is bought to close (BTC).
Put sellers receive a premium from the buyer. The buyer is paying the seller for the right to sell the stock to the seller in the future. Put sellers want the price of the stock to go up. Why? If the price goes up, the buyer will have no reason to assign the stock since they could sell the stock for more at the current market price. In this case, the seller gets to keep the premium paid by the buyer.
Exercise and Assignment
Most stocks and ETF’s are American style options. This means that if the buyer of an option chooses to exercise or assign their rights they may do so at any time prior to expiration.
Indexes such at
SPX
,
NDQ
and
RUT
are European style options. This means that any exercise or assignment may only occur at expiration. Who wins when the stock moves?
1. Buyers of Calls – win when the stock goes up
2. Sellers of Calls – win when the stock goes down
3. Buyers of Puts – win when the stock goes down
4. Sellers of Puts – win when the stock goes up
Are you new to options trading? Stay tuned for Part 3 of Trader's Guide to Options which will include in-the-money, at-the-money, and out-of-the-money options as well as the reality of trading.
