What Are Options?

Options Trading Basics


Introduction

Options are simple, but more complex than buying or selling stock. Because options are different, people who don't understand how options work say that options are risky.  Options do have some risk, just like stock buying. However, it would be dishonest or misleading to say they are more risky than stock because in fact, buying options costs a fraction of the stock price making your risk a fraction of the stock price. Options come in two basic types, calls and puts. With that introduction, this page will explain stock options in great detail.

Call Options Defined


"Call options are stock derivative assets that give option holders the right, but not the obligation, to buy 100 shares of the underlying asset at the strike price before the options expire."

If you are new to options, there were a few terms and phrases in that definition that you may not recognize. Throughout this site, click on the terms to get a more detailed explanation of the term or phrase that is highlighted.

When you buy a call option, you are entering a contract by paying a premium and you are purchasing a right. With this right you get the power to make a choice. You will keep this right until the expiration date of the option. This right could come in handy. To illustrate how the call option could come in handy, we'll start with an example of a stock trade.

Let's pretend you believe a stock that is currently trading at $99 per share will soon move above $100 per share. You could pay $99 per share for 100 shares of stock. This would cost you $9,900. 

Now let's pretend you are right and a month later the stock moves to $105 per share. You can now sell your 100 shares of stock for $10,500. This is a profit of $600 or about a 6% gain in one month.

Below is a profit/loss graph of buying stock on AAPL.

Now we'll demonstrate how the call option could come in handy. 

Let's pretend you don't have $9,900 to buy 100 shares of the stock you believe is going up above $100 per share. Let's pretend that you can buy a call option for $100 for one option contract. This contract gives you the right but not the obligation to buy shares at the $100 strike price any time in the next month and it only costs you $100 to buy it.

Using the same scenario as above, the stock moves up in price to $105 per share. You have the right to buy 100 shares at $100 per share. You could sell those shares in the open market for $105 per share. If you exercise the right you purchased, you have the right to buy 100 shares for $10,000 and immediately sell them for $10,500. This gives you a profit of $500 minus the $100 you paid for the option. 

Your total profit in this scenario would be $400 on a $100 option investment. That's less than the $600 profit the stock trader made in this scenario, but you didn't have the $9,900 to buy the stock. To that point you didn't have the $10,000 you would need to exercise your right either, so instead of exercising your right, you could instead sell the option for the exercise value of $400.

You would likely sell it for a little cheaper than $400 exercise value to give the buyer some room to profit by taking the option off your hands.

The stock trader made a profit of 6% over the month. The option trader may not have made as much money in cash, but they did make a 400% profit on the amount of capital used to buy the option. If the stock trader had bought 99 options instead of 100 shares, they would have made $39,600 instead of $600.

Call options can make a profit in a couple of different ways. When the stock price moves above the strike price of the option, the option will gain exercise value. But the option price will change even if the stock does not move above the strike price. That is because the option has not expired and it still has time before the expiration.

The value on an option when it has no exercise value is called time value. Most options that still have time before expiration will have some time value. An options price can be broken up into time value and exercise value.

Call options make money as the stock moves up or as the probability increases that the stock will move up enough that the option will have exercise value at expiration. This is a profit/loss graph for a call option buyer on DLTR stock. 



In this graph you can see that the call option has unlimited profit potential just like a stock purchase would. The net debit, represents the cost of the option per share that you have the right to buy. In this case with a net debit of 1.4 your option would cost $140 per 1 contract. That is because this one contract gives you the right to buy 100 shares.

The position greeks are explained on the option terminology page. This particular trade is a weekly option and has 7 calendar days till options expiration.

The dashed yellow line shows the current stock price which is also shown in the title of the graph. The x-axis shows where the stock could be at options expiration. The red section shows the option loss if the stock if the stock finished at the price on the x-axis. The option loses if the stock finishes less than the 83.5 strike price plus the 1.4 option price.

The green section shows the range where the option would be profitable if the stock moved more than $1.4 above the strike price. This is called the breakeven point.

Notice that no matter how far down the stock moves the loss is limited to the cost of the option. That is because you have the right to buy shares but you are not obligated to do so. It is your choice. In the worst case scenario you choose not to exercise your right to buy shares, the option expires and you lose your right as wells as the money that you paid to obtain it.

The cost of the option is not refundable, however, you can sell it to someone else if they are willing to pay for it. The cost of the option goes to the option grantor. They get to keep the premium and they are obligated under the contract to deliver 100 shares of the stock to you at the strike price if you decide to exercise the right that you purchased. 

Just as the holder can sell the option to someone else, the grantor can buy the option back and remove the attached obligation to deliver shares at the strike price. This is a profit/loss graph for the option grantor in the above DLTR call option example.

Notice that this graph is almost the exact opposite of the holders profit/loss graph above. The flat green area shows the maximum profit of selling call options is limited to the bid price of the option. In this case the option seller would get .40 to sell the option and take on the responsibility to deliver shares at the 83.5 strike price.

The red area shows that the grantor of the option has unlimited loss potential, if the person selling this option did not already own the shares, as they would in a covered call. In this case they would be forced to buy the shares in the open market and deliver them at the strike price or they would be assigned a short position in the stock which also has unlimited loss potential.

Selling call options without owning the stock is not recommended!

Summary

Call option holders pay a premium to obtain the right to buy shares of the underlying stock at the strike price before the option term expires. They do this because they believe the stock will rise above the strike price by more than the cost of their option. Call buyers have unlimited profit potential and because they are not obligated to buy the shares, they have limited risk. The breakeven point of a long call is the strike price + the net debit. The max loss is the net debit.

Call option grantors receive a premium and take on the obligation to deliver shares of the underlying stock at the strike price before the option term expires. They do this because they believe the stock will not rise above the strike price by more than the premium they received when they sold the option. Call sellers have limited profit potential and unlimited risk if they do not already own shares of the underlying stock. The breakeven of a short call is the strike price + the net credit. 


Put Options Defined


"Put options are stock derivative assets that give option holders the right, but not the obligation, to sell 100 shares of the underlying asset at the strike price before the options expire."

When you buy a put option, you are entering a contract by paying a premium and you are purchasing a right. With this right you get the power to make a choice. You will keep this right until the expiration date of the option. This right could come in handy. To illustrate how the put option could come in handy, we'll start with an example of a short stock trade. NOTE: Profits from stock trades come from buying low and selling high, but it doesn't have to happen in that order. You can sell high and then buy low as you would in a short stock trade.

Let's pretend you believe a stock that is currently trading at $101 per share will soon move below $100 per share. You could borrow shares using cash collateral as margin with some rate of interest through your broker and sell them short at $101 per share for 100 shares of stock. This would bring in $10,100 and it would obligate you to return the shares that you borrowed to release your collateral margin at a later date. 

Simple stock positions may not be as simple as they sound. Especially when selling short.

Now let's pretend you are right and a month later the stock moves to $95 per share. You can now buy 100 shares of stock for $9,500 and return them to meet your obligation as promised. This results in a profit of $600 or about a 6% gain in one month minus the interest on your borrowed shares.

Below is a profit loss graph of a short stock position on TSLA

Now we'll demonstrate how the put option could come in handy. 

Let's pretend you don't have $10,100 plus the margin requirement to sell short 100 shares of the stock you believe is going below $100 per share. Let's pretend that you can buy a put option for $100 for one option contract. This contract gives you the right but not the obligation to sell shares at the $100 strike price any time in the next month and it only costs you $100 to buy it.

Using the same scenario as above, the stock moves down in price to $95 per share. You have the right to sell 100 shares at $100 per share. If you did buy 100 shares paying $9,500 and you immediately exercise your right to sell the 100 shares you just bought for $10,000 you would  profit $500 minus the $100 you paid for the option. 

You could argue that buying a put option is more simple than selling short the stock. Because you don't have to think about borrowing costs that can rise if the stock doesn't do what you are expecting it to do.

Instead, as a put buyer, you have rights and you get to choose to buy low and sell high only after you see how your expectation turned out. This is a much less risky way to handle a bearish expectation.

Your total profit in this scenario would be $400 on a $100 option investment. That's less than the $600 profit the stock trader made in this scenario, but we were pretending you didn't have the $10,100 plus margin to sell short the stock. In order to exercise your right you would need the $9,500 to buy the 100 shares in the open market before you exercise your right to sell shares. But if you didn't have the money to buy those shares, you could instead sell the put option for the exercise value of $400.

You would likely sell it for a little cheaper than $400 to give the buyer some room to profit by taking the option off your hands.

The stock trader made a profit of 6% over the month. The option trader may not have made as much money in cash, but they did make a 400% profit on the amount of capital used to buy the option. If the stock trader had bought 99 put options instead of selling short 100 shares, they would have made $39,600 instead of $600.

Like call options, put options can make a profit in a couple of different ways. When the stock price moves below the strike price of the option, the option will gain exercise value. But the option price will change even if the stock does not move below the strike price. That is because the option has not expired and it may still have time before expiration.

Put options make money as the stock moves down or as the probability increases that the stock will move down enough that the option will have exercise value at expiration. This is a profit/loss graph for a put option buyer on KO. 

In this graph you can see that the put options profit potential makes money as the stock moves down just like a short stock position would. It will continue to add profit until the stock price reaches 0. The net debit, represents the cost of the option per share that you have the right to sell. In this case with a net debit of 0.9 your option would cost $90 per 1 contract. That is because this one contract gives you the right to sell 100 shares.

The position greeks are explained on the option terminology page. This particular trade is a monthly option and has 35 calendar days till options expiration.

The dashed yellow line shows the current stock price which is also shown in the title of the graph. The x-axis shows where the stock could be at options expiration. The red section shows the loss value of the put option when the stock price at expiration matches the x-axis. The option would lose money if the stock finished above the 52.5 strike price minus the 0.9 option price.

The green section shows the range where the option would be profitable if the stock moved more than $0.90 below the strike price. This is called the breakeven point.

Notice that no matter how far up the stock moves the loss is limited to the cost of the option. That is because you have the right to sell shares but you are not obligated to do so. It is your choice. In the worst case scenario you choose not to exercise your right to sell shares, the option expires and you lose your right as wells as the money that you paid to obtain it.

The risk of buying a put is so far below the unlimited risk of selling short the stock that it almost doesn't make sense to sell short stock when you have the choice to buy a put.

The cost of the option is not refundable, however, you can sell it to someone else if they are willing to pay for it. The cost of the option goes to the option grantor. They get to keep the premium and they are obligated under the contract to buy 100 shares of the stock from you, the holder, at the strike price if you decide to exercise the right that you purchased. 

Just as the holder can sell the option to someone else, the grantor can buy the option back and remove the attached obligation to buy shares at the strike price. This is a profit/loss graph for the option grantor in the above KO put option example.

Notice that this graph is almost the exact opposite of the holders profit/loss graph above. The flat green area shows the maximum profit of selling put options is limited to the bid price of the option. In this case the option seller would get .87 to sell the option and take on the obligation to buy shares at the 52.5 strike price.

The red area shows that the grantor's loss potential is only limited by the stock reaching 0. Under the terms of the contract, the put option seller would have to buy the shares from holder at the strike price even if the stock was completely worthless if the holder decides to exercise their right.

Selling put options can be a great alternative way to buy stock at a price that is lower than the market price!

Summary

Put option holders pay a premium to obtain the right to sell shares of the underlying stock at the strike price before the option term expires. They do this because they believe the stock will fall below the strike price by more than the cost of their option. Put buyer's profit potential is only limited by the stock falling to 0 and because they are not obligated to sell the shares, they have limited risk. The breakeven point of a long put is the strike price minus the net debit. The max loss is the net debit.

Put option grantors receive a premium and take on the obligation to buy shares of the underlying stock at the strike price before the option term expires. They do this because they believe the stock will not fall below the strike price by more than the premium they received when they sold the option. Put sellers have limited profit potential and there risk the amount of the breakeven point. The breakeven of a short put is the strike price minus the net credit.

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