In the world of investing, a derivative is a financial security that derives its value based on the price movements of another investment. The derivatives universe is large and complicated, and typically, they are not easy concepts to understand. Options contracts, such as stock options, are an example of such investments available for trade – and, like most derivatives, the definition and function can initially be difficult to grasp.
There are several uses for options contracts in investing, including:
The purpose of this introduction to options is to provide you with a fundamental understanding of what options are, how they work, and how you can use them. (Be on the lookout for more advanced options strategies in future articles, too!)
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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An option is a contract that gives the owner the right, but not the obligation, to either buy or sell an investment at a specified price, depending on the type of option. The purchase or sale price that is specified on the contract is referred to as the strike price.
A call option gives the owner the right to buy an investment at the strike price.
A put option gives the owner the right to sell an investment at the strike price.
Each options contract that an investor purchase grants them the right (again, not the obligation) to buy or sell 100 shares at the strike price. For example, if you own 5 stock option contracts, you have the right to purchase 500 shares of the equity investment at the strike price.
There are options contracts for almost everything, including:
Savvy investors can use options to protect against a loss, lock in a gain, create portfolio income, or speculate on the price of a particular type of investment.
The best way to understand options is by understanding that there are two sides to the contract: the owner and the seller of the option. As discussed, the owner of the contract has the contractual right, but not the obligation, to exercise their option. The owner of the contract pays a premium in order to purchase the contract.
The seller of the options contract receives the premium. When you hear the term “writing an options contract,” that is what is being referred to. Selling options contracts is a common way of generating portfolio income with derivatives as an investor.
The seller of the option has the obligation to either buy or sell the shares if the contract holder decides to exercise their options.
Notice how this is different from the owner of the contract. You can even say that the seller of the contract is at the mercy of the contract holder. Whenever the seller of the contract either sells or buys the shares stated on the options contract, this is referred to as an assignment.
If a call option owner exercises their option, the seller of the option has the obligation to sell the shares to the contract holder at the share price.
What if the seller doesn’t already own the shares? They would have to purchase the shares at whatever the market price of the investment and sell them to the contract owner at the strike price. This is referred to as selling a “naked call.” This can be extremely risky, because the share price can continue to climb, in theory.
If you plan to sell an options contract, it’s typically advisable that you own the shares prior in case you get assigned. Different brokerage providers have different policies when it comes to the assignment.
If you are the owner of the options contract, you are in the driver’s seat. You can decide whether or not you want to purchase the shares at the strike price, as long as you exercise before the expiration of the options contract.
Exercising your options simply means placing the order to either buy (call) or sell (put) the shares at the strike price listed on the contract.
The term of an options contract can vary from near-term to longer-term (in the case of LEAPs). While the dates for expiration can vary, options contracts expire on the third Friday of every month.
If a contract holder does not exercise by the expiration date, the option expires. This means the contract holder no longer has the right to purchase or sell the shares at the strike price. Different brokerage providers have different policies for how they deal with options that are about to expire. Some will even try to attempt to exercise the options for you if you have the purchasing power (cash) in your account to do so.
Note that there are several styles of options contracts. You can exercise American Options at any time prior to expiration. In contrast, you can only exercise European Options at expiration.
There are a few terms that traders use to describe the moneyness of an option or the relationship between the current price and the strike price. As a reminder, the strike price is the price stated on the contract that the owner of the option can either purchase or sell 100 shares at if they wish.
An options contract that is “in the money” is currently profitable.
In the case of a call option, this means that the current share price of the underlying investment is above the strike price. For example, let’s say the strike price of a call option is $50. If the stock is trading at $55, the option is in the money by $5.
If it’s a put option, the current share price needs to be below the strike price in order to be profitable. Using the previous example, if the strike price is $50 and the shares are trading at $45, the put option is in the money by $5.
Note: an option must be in the money in order for the contract holder to have the ability to exercise it.
An options contract that is “out of the money” is not currently profitable.
In the case of a call option, this means that the current share price of the underlying investment is below the strike price. For example, let’s say the strike price of a call option is $50. If the stock is trading at $45, the option is out of the money by $5.
A put option, on the other hand, is not profitable if the share price is above the strike price. Using the previous example, if the strike price is $50 and the shares are trading at $55, the put option is out of the money by $5.
Note: A contract holder CANNOT exercise their option if it is currently out of the money.
An options contract is “at the money” if the underlying investment trades at the strike price. Note that this does not mean that the option is automatically profitable. Remember, you have to pay a premium to purchase the shares.
Let’s say that the premium on a contract was $5. If the strike price is $50 on a call option, the share needs to be trading at $55 to break even. Any price above $55 would be considered profitable. In the case of a put option with a premium of $5 and a strike price of $50, the breakeven point would be $45. Any price below $45 would be considered profitable.
Often, investors trade the actual options contracts instead of exercising them.
Why? Because options contracts have a marketable value, just like a stock.
There are two variables that play into the value of an options contract: time and the price of the underlying security.
Intrinsic value refers to the spread between the strike price and the current share price of the underlying investment.
As it relates to call options, the underlying investment’s price has to be ABOVE the breakeven point in order for the option to have intrinsic value. If you own a put option, the share price has to be BELOW the breakeven point in order for the options contract to have intrinsic value.
The “deeper” the options contract is in the money, the higher the intrinsic value. If an options contract is out of money, the contract has NO intrinsic value.
Note: if the options contract is currently sitting at breakeven, there is still no intrinsic value because exercising the option would not be profitable.
What if the contract is out of the money? Does this mean has no value? Not necessarily.
As mentioned, time plays an important role in the equation. This is referred to as time value.
Generally speaking, the more time that an options contract has until expiration, the more time value it has. If an options contract is out of the money, but there is still some time between then and expiration, the options contract only has a time value.
This is why you can still trade options that are out of the money.
Different brokerage providers have different policies when it comes to applying for the ability to trade options.
Because it is such a risky practice, firms do their due diligence to make sure that you have the capacity to trade options. Some even highly suggest you go through some of their educational material on options prior to applying.
In the options application, firms will ask for information about you, such as your financial situation and your trading experience.
Some firms have different “levels” of options trading that they will allow you to do. If you are just getting started with options, they may not give you free rein over all of the different options strategies you can deploy, including trading naked options.
The firm will also ask you to complete an options agreement, which more or less states that you understand how options work and the risks involved with them. Some firms will ask for additional documents if you want to deploy more complicated strategies. After applying and providing all of the required documentation, the firm will come back to you with a decision. If you are approved, you will be free and clear to start trading options.
Again, different providers have different policies. It is very likely that the firm will ask that you have sufficient cash or margin buying power before placing specific types of orders (like naked puts).
If you’ve learned anything from this introduction to options, it should be that options can be extremely risky investments. Before engaging in any type of options trading, make sure that you understand the risks involved with the practice.
There are professional investors that stay away from options altogether. Peter Lynch referred to options trading in a similar light to day trading in his book One Up on Wall Street.
It is advisable that you get a real feel for your risk tolerance via traditional investing before applying to trade options. If you want to practice trading options without real money, you can open a “paper trading account” online. This will give you a feel for how volatile options can be.
It is also advisable that you study the underlying security that the options contract represents, as the price movement of that investment has a direct correlation to the volatility of the options contract. The more volatile the underlying security, the more volatile the options contract.
If you want to learn more, some great books on the subject include:
Have questions on options? Let us know!