Options – Explain It Like I Am A Five Year Old

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by HSeldon2020

I have been asked by several people to explain the basics of Options Trading (and to do so in a way that is easy to understand).

Once again this is for those that either do not understand Option trading or need a refresher.

While I am not sure it is entirely possible to cover the all the complexity inherent in this subject in one post, hopefully this will give you a solid fundamental understanding of Option Trading. I will try to keep it as simple to understand as possible.

Nevertheless, I still urge you to check out the tutorial videos your broker most likely provides – for example, Ameritrade has an excellent Options training “course”.

Also – please know that reading this does not mean you should start trading Options. Until you have practiced using them with consistent success, I caution against trading them with real money.

Options:

The concept/theory of option contracts have been around for a long time, probably since the conception of trading goods/commodities began. In a way, the entire Insurance industry is based on the same principles. For the stock market, Option trading has been open to traders since 1973 (so they are as old as I am). And that is what Options are – a contract.

Just as with any contract you can either be the person who is writing the contract, or the one that is buying it.

All contracts are based on two things – the current and the future price of an underlying (in this case, Underlying refers to stocks, commodities, ETF’s – like SPY). For the purposes of this post, I will be using stocks as the underlying example.

The difference between buying an option contract and buying the actual underlying is when you buy a stock, you actually own that stock – it is an asset; however, when you buy an Options contract you own the contract. You are paying for the right to buy (or sell) a 100 shares of a stock. Essentially you have not yet paid for the stock, you have simply paid for the right to act on that stock at a future date.

Now one might think that only institutions can write (i.e. sell) Option contracts, but actually anyone can sell them – you just need to have the money in your account to back it up.

Still confusing? Here’s an example:

The housing market is currently going up, a lot. But you are afraid if you buy a house now, the market might crash. You are also afraid that if you don’t buy now, it will keep going up. After looking at different properties you finally find one that you love – it is listed for $1 million. You feel that you will know either way what the market will do within the next two months, but you don’t want to risk buying the house now.

So how much would you pay the owner of the house to lock in the price of $1 million for you? So that if in two months the house is now worth $1.5 million, you can still buy it for a million, but if it drops to $800,000 you don’t have to buy it at all? Let’s say the owner offers you a deal – if you pay them $25,000 now – they will guarantee you the house at $1 million and you can buy it for that at anytime in the next two months. They also tell you that this contract is transferrable, meaning you can sell it to someone else for whatever amount the market will bear. So you pay the owner $25K. And the house goes down to $900K after 1 month. Now you can either wait and hope the price goes back up. You can sell your contract to someone else, but it would be worth much less than 25K now (i.e. why would someone pay $25K for the right to buy a house for $1 million when they can buy it right now for $900K?). The person taking that deal would have to be extremely bullish on housing to agree to pay you for a contract that gives them to right to buy the house for $100K over asking price (if you think this sounds like a bad deal, it is exactly what you are doing when you buy an Out-Of-The-Money Option). Maybe if they are very optimistic on the housing marketing still, and think in the next month that house is going to go to $1.4 million and they have no intention of buying the house but know they can sell that contract again for more than they paid you for it, they might being willing to do a deal, but it is going to be for less than $25,000. Now, if the price of the house goes up to $1.2 million, you just made a lot of money. You can either exercise your contract and buy the house for $1 million – you lose the 25K it cost for the contract, but made $200K on the house. If you wanted you can turn right around and sell the house for $1.2 million and make $175,000. Or you can sell your contract to someone else – the right to buy a $1.2 million house for $1 million, with a month left to go on the contract would be worth more than $200K. Or you can hold the contract and wait to see if the house keeps going up in price (thus, increasing the value of your contract).

Notice that unless you exercised the contract, you did not buy the house – you just bought the right to lock in a price.

So now with stocks:

Stock A – current price is $100.

If you are bullish on Stock A, you can buy the stock. So you buy 10 shares for $1,000. You now own that stock. If it goes up you can sell it for a profit, if it goes down you can sell it for a loss, or you can hold it. As long as the company is listed on the exchange, you can hold your shares indefinitely.

If you are bearish on Stock A, you can short the stock. So you borrow 10 shares from the broker for $1,000 and immediately sell them – collecting the $1,000. But you still owe your broker 10 shares of Stock A. If the price goes down to $95, you can buy back the 10 shares for $950 and give those shares back to your broker, keeping the $50 difference. If the price goes up to $105, you now have to buy back those shares for $1,059 and give the shares back to the broker, losing $50.

However, let’s say that you think the amount of profit you can expect off owning (or shorting) 10 shares of Stock A simply isn’t worth it. Well options allow you to use leverage.

There are two types of Options – Calls and Puts. And remember, a single contract of either a Call or Put always refers to 100 shares of the underlying. As such, the price of an option contract is multiplied by 100 – so if it costs $1, that is saying it costs $1 per share, meaning the actual cost is – $100.

Call option contract gives the buyer of the contract the right (but not the obligation) to purchase a stock at a set price on a set date.

Put option contract gives the buyer of the contract the right (but not the obligation) to sell a stock at a set price on a set date.

What is important to note here is that you do not need the money in your account to actually buy 100 shares of Stock A ($100 * 100 = $10,000), nor do you need to actually have 100 shares of Stock A to sell to somebody. All you need to have is enough Option Buying Power to pay for the cost of the contract itself. However, if the contract is about to expire you will be warned that you could be in a margin call soon (meaning you might be forced to buy 100 shares of a stock you can’t afford or sell 100 shares of a stock you do not have).

So let’s look at four scenarios on the same Stock:

Scenario 1 – Buying a Call: Stock A is currently going for $100 per share. You think it is going to go much higher in the next couple of weeks. So you buy a contract that say you have the right but not the obligation to purchase 100 shares of Stock A at a price of $95 a share (this is known as the strike price) in two weeks time (known as the expiration date). This is called an In-The-Money Option. Given that the price of the Stock is $100, one would think the person selling you that contract that let’s you buy the stock at $95 would charge $5 per share, or $500 per contract for this transaction – as this is the intrinsic value of the option. Options that have intrinsic value are In-the-Money. However, what would be the benefit to the seller of the contract in that case? They are getting no benefit from selling you that contract. Because they would be selling Stock A to you for $95 a share, which is cheaper than the going rate (i.e. they could just sell Stock A themselves for $100 a share), so the $5 charge would just be to make up the difference. Since they want to make a profit, they are going to charge you a premium on top of that intrinsic value to get some benefit. That premium is calculated using various factors and set by the market-makers (explained later); however, you are primarily going to be charged for time (this is called Theta – time decay) and for how volatile the stock is (Vega – volatility). The more time on the contract, and higher the volatility in the stock, the more premium you will pay for it. For this example, let’s say in this case to buy a Call for Stock A with a strike price of $95, when Stock A is worth $100 will cost you $6 for this contract, or $600. Obviously, if you bought this option and then immediately exercised it, you would be able to buy 100 shares at $95, and then you could sell it for $100 – thus, making $5 a share – but it cost you $6 a share to have the right to do that, so in the end you have lost $1 a share. Hence, why you are hoping for the price to go up – but now you know the amount you need it to go up to – which is to $101 by expiration. You need Stock A to be at least at $101 at the expiration date to break-even. Anything over $101 and you are in profit. However, this is if you intend to exercise your contract. And here is the other important note about options – Most traders never intend to exercise their contracts.

Essentially what you are trading are the contracts themselves.

If after one week since you bought the call option at a strike of $95, for $6 a contract, Stock A was at $102 – an increase of $2 per share, the contract would now have an intrinsic value of $7 ($102 – $95) and then when you add on the remaining time decay and increased volatility (since it just moved 2% in a week, from $100 to $102), the current value would be around $8.50 per share, at 100 shares = $850. Since you paid $6 per share ($600), you could now sell this contract to someone for a profit of $2.50 or $250.

Scenario 2 – Buying a Put. Now let’s say you are bearish on Stock A, and not just bearish, but very bearish. You think it is going to fall a lot. So you buy a Put Option that expires in two weeks, at $97. This means you have the right, but not the obligation, to sell Stock A at $97. However, at the time you bought this Put if it were exercised you would have to buy 100 shares at the current rate ($100) and then turn around and sell it at the contracted rate ($97) – meaning you would lose money. Since the Option is currently in a losing position it is known as an Out-of-the-Money Option. And guess, what? You still have to pay a premium to own something that is currently in a losing position. However, since there is no intrinsic value to add to the price of the Option, you are paying all premium, which is cheaper than an option that does has *intrinsic value (*people are drawn to Out-of-the-Money Options because they are cheap). Let’s say you pay .50 cents ($50) for the right to sell Stock A for $97. When you buy the contract, you currently hold a contract that has $50 of value. However, if Stock A stays the same price or goes up, your contract will be worth less and less, eventually down to $0 (meaning you lose the entire $50). However, if Stock A drops and goes to $98 in the first week your contract might be worth .90 ($90), at which point you could either sell it and make $40 profit, or hold it, hoping the stock goes down more. However, as time ticks on, the value of your contract declines based on Theta. With your contract Out-Of-The-Money you are constantly fighting against time, hoping the stock drops in price (with a Put) which raises the value of the contract, faster than Time Decay decreases the value.

Both of these scenario involve you Buying contracts. As mentioned, you can also sell contracts.

Scenario 3 – Selling a Put. Selling Puts are considered a bullish strategy (Note: Selling Options requires a higher margin balance). So let’s go back to Stock A. You like it and want to buy the stock, but feel it is a bit over-priced at the moment. But you will be happy to buy it at $95. So you sell Puts at the strike of $95 with an expiration date of one month. And let’s say you collect, .35 ($35) per contract that you sell.

If Stock A closes above $95 on expiration day, you keep the $35, and move on to the next trade. However, if Stock A closes below $95, you now have to buy 100 shares of Stock A for the agreed upon price of $95. If the stock falls to $93, clearly you have lost money on the deal, but since you got .35 cents per share, you really only paid $94.65 per share, meaning you are down $1.65 per share on the trade. However, if you had just bought the stock at $100, you would be down $7 per share. So yay for you?

Just like with contracts you bought, you can also trade the ones you sell. Let’s say Stock A dropped to $97 and there is 3 days left. But you are afraid it is going to keep dropping and you do not want to risk it falling below your strike price of $95. You no longer want to own it at $95, and your contract is now worth .15 cents (even though the stock dropped in price, Time Decay lowered the price of the contract faster than the price decreased helped it). You can buy back that contract you sold for .35 cents for .15 cents and make .20 cents ($20) on the deal.

If you have the money is your account to buy 100 shares of Stock A at $95 ($9,500), this is called a Cash-Secured Put. Your broker will require you to put up a share of that $9,500 in margin to protect themselves.

As you can see, selling Options can be very dangerous. When you buy options your loss is maxed out at the price your paid for it (i.e. if you paid $4 ($400) for a Put, and the stock didn’t go down, and you just let the contract expire, you could only lose $400), but when you sell Options, your loss can be much greater. Selling Puts, your loss is theoretically the price of the stock times 100 – meaning if you sold a $95 Put, and the stock went down to $0 (never happens really), you would still be forced to buy 100 shares at $95 for a stock now worth $0, meaning you lose $9,500 (minus the .35 cents ($35) you received for selling the Put).

Scenario 4 – Selling a Call . Selling a Call is technically a Bearish strategy. If you sold a call on Stock A (worth $100 per share) with the strike price of $100 (since the strike price is equal to the actual price, this is known as At-The-Money) this means you are agreeing to sell the other person 100 shares of Stock A at the price of $100. Now there are two ways to do this – Covered and Naked.

Covered Calls means you already own 100 shares of Stock A. Maybe you bought them a long time ago, or perhaps you just bought them now for the purpose of doing a Covered Call. Either way, if the stock goes up to $105 by the expiration date, you must give away your shares at $100 per share. You would have received some premium for selling the call, and since it was At-the-Money the premium you received would be somewhat higher than if it was Out-of-the-Money. Basically, if you are selling a Call on Stock A at the strike price of $105 with an expiration of 2 weeks, while the stock is currently $100, the person buying that call is only going to make money if Stock A goes up by a lot. So let’s say they pay .25 cents ($25). You have a high chance of not only keeping that $25 but also keeping Stock A since it would have to go up beyond $105 before anyone could call your shares away (hence the name Call Option). Whereas, an At-the-Money Call would be worth more, perhaps around $1 ($100). Most people use Covered Calls to generate income off stocks they own. For example if I own 500 shares of AAPL, and each week I sell an Out-of-the-Money Covered Call on it, it would go something like this:

AAPL – currently at $148.97. I sell the call expiring 9/17 with the strike of 160 for .25 cents ($25). Since I have 500 shares, I sell 5 contracts, netting me $125.

If AAPL goes up to $159.99 by expiration, I not only collected $11.02 from the stocks I own, but all the additional $125 from selling the calls. And I get to keep all my shares.

If AAPL goes up to $150 by expiration, it is the same thing, except I collected $1.03 from the shares, and $125 from the Call I sold. And I get to keep all my shares.

If AAPL goes up to $160, I collected $11.03 from the shares and the $125 from selling the Calls, but would have lost the shares for the price of $160.

If AAPL goes up to $165, I collect $11.03 from the shares and the $125 from selling the Calls, but I lost any gains over $160 as I had to sell the shares to the person who bought the contract.

If AAPL goes down to $147 by expiration, I lose $1.97 per share (which I would have lost any way since I own the shares), but made .25 per share from selling the Calls, so it cushioned the loss by roughly 13%. However, as I saw AAPL dropping it now became difficult to sell my shares and avoid further loss until I close out the Calls I sold (if I sell my shares, I would be left with a Naked Call which is very dangerous).

Naked Calls are when you sell Calls on an underlying without owning the required 100 shares per contract to cover it. This is one of the most dangerous trades you can make, and requires the highest level of trading approval from your broker. Why? Because if you sold those $105 strike calls on Stock A and did not own them, and suddenly Stock A announced it is releasing an innovative new product – sending their stock to $175, you now owe $70 per share ($7,000).

A few other things to take note:

Greeks – Other than the intrinsic value of an option, there are various components that go into the pricing of the contract. These components are known as the Greeks. Throughout the post I mentioned time-decay and volatility – known as Theta and Vega respectively. There are also two other major Greeks known as Delta and Gamma.

Delta – Back to good ole’ Stock A (price currently – $100) and you bought an In-The-Money Call with a strike price of $98 for $3 ($300). You would expect that as the stock goes up $1, the value of your Option contract would also go up by $1, right? Not exactly. It will go up $1 times Delta. So if Delta is .6, that means, that when the stock goes up by $1, from $100 to $101, your $3 Option would now be worth $3.60 – going up by .60 cents. Delta also tells you the markets belief of the likelihood that Option will be In-The-Money at expiration, and a Delta of .6 is saying that consensus is there is a 60% chance Stock A will be above $98 at expiration.

Gamma – So let’s say Stock A did go up by $1, and your Option value increased by 60 cents. That means your $98 strike Call Option is even deeper In-The-Money now than it was when you bought it. So the Delta should be higher. Another way to think about it is – if the stock went from $100 to $101, the chance that Stock A will finish above $98 by expiration should now be higher than 60%, so the Delta should have increased. How much will the Delta now be worth? How much of an increase in value in the Option should you expect if it goes from $101 to $102? Gamma tells you that. If Gamma was .07 when you bought the Option, than Delta will increase by .60 + .07 =.67 after it went from $100 to $101. Now that it is at $101, Gamma will also change as well.

Remember, the deeper In-The-Money your Calls/Puts are, the higher the Delta will be and the more leverage you will have. In other words, you want your Option contract to increase in value penny for penny with the underlying. If you have a Call and the underlying goes up 50 cents, you want your Option contract to also increase in value by 50 cents. Deep In-The-Money Calls give you the best 1 to 1 leverage. Whereas far Out-of-the-Money calls might only have a Delta of .1, meaning the underlying could go up $1 and the value of your contract only increases by 10 cents.

Vega – This Greek reacts to changes in implied volatility. Higher levels of implied volatility tells you that the underlying is subject to larger swings in price. For example, as earnings for a stock approach, implied volatility will be high, as there is an expectation of larger than normal movement in the stock. Vega measure the impact on the price each percentage point change in implied volatility will have – which is why buying Options and holding them over earnings subjects you to an IV Crush (and is generally a bad idea overall). Example:

Stock A (price of $100 per share) has earnings coming up on 9/14 and the option expires on 9/17 – the Implied Volatility is 145%. An Out-Of-The-Money Call at the strike price of $102 goes for $3.50 ($350). This means that Stock A needs to get above $105.50 for you to be in profit at expiration (if you do not understand why that is, go back an reread this post from the beginning). Let’s say Stock A does well on earnings and the next day is at $104, meaning it went up $4 in price, or 4% – which is a pretty big increase. But your Call Options are now worth $2.75 ($275) – with $2 ($200) of it being intrinsic value and only .75 cents ($75) in premium. You actually lost .75 ($75) on the trade even though the stock went up 4% in value. Why? Because implied volatility dropped from 145% down to 30%, since there is no longer an event coming up that could cause a huge swing in the price. The big change that was expected already occurred, and thus the stock is no longer seen as volatile as it was before.

Theta – Finally you have Time Decay. When you buy an Option, Time Decay is not your friend. The clock starts to tick the moment you buy the stock and it accelerates as you get closer to expiration. Every day you hold that Option (including weekends) the value of your contract is decreasing by Theta. If Theta is .74 cents ($74), you are losing 74 cents ($74) per day in the value of that contract. However, if you sold the Option, then you are on the other side of Theta and you want to see Time Decay tick away at the value. When you sell an Option, you ideally want it to be worth $0 at expiration.

Options can be used for Day TradingSwing Trading and even long-term Investments. I have other posts that deal with Option Strategies, but this one is primarily for those that wanted to get a base understanding of the instrument from the beginning.

These are basics of Option Trading. There are various combinations you can do with these options, which are called spreads and that is for another post. Before you even consider doing spreads, you need to make sure you understand the basics laid out in this post.

Hopefully this answered some of your questions.

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.

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