Concepts and Definitions
Options trading is the buying and selling of an option, a contract that gives the bearer the right, but not the obligation, to buy or sell an underlying asset for a specific price and within a specific time frame.
At its core, Options Trading is about the right to make a trade in the future at a price decided today. It’s like having a voucher for a sale price on your favorite gadget that you can use before it expires, whether the price of that gadget goes up or down. In this chapter you will learn the definitions of terms and fundamental concepts that make up option trading.
CALL OPTIONS
A call option gives the option holder the right to buy the underlying asset for the strike price before or on the expiration date. Buying a “call” option is paying a fee today to lock in the purchase price for a date in the future.
As an example, let’s say you’re bullish on a tech company’s stock, currently priced at $100. You could buy a call option with a strike price of $105 for a small premium say $3. If the stock goes up to $120, you can exercise the option and buy the stock at $105 even though it is trading at $120. In contrast, if the stock goes down instead, you lose your $3 premium and the person that sold you that option keeps the $3 premium.
You can only make money on a call option if the price of the stock, at the time of expiration, exceeds the strike price minus that amount paid for to buy the call.
PUT OPTIONS
A PUT option gives the option holder the right to sell the underlying asset for the strike price before or on the expiration date.
As an example, let’s say you are bearish on a company’s stock currently priced at $100. You could buy a put option with a strike price of $95 for a small premium say $3. If the stock goes down to $80, you can exercise the option and sell the stock at $95 even though it is trading at $80. In contrast, if the stock goes up instead, or is selling above $95 you lose your $3 premium.
Opposite a call option, if you bought a PUT, you could only make money on a put option if the price of the stock, at the time of expiration, is below the strike price minus that amount paid for to buy the put.
OPTION EXPIRATION DATES
Every option you buy or sell comes with a contract expiration date that will end on a Friday. You can buy or sell options for indices (such as the S&P 500 or QQQ) that may expire during each day of the week. But for actual stock options on individual stocks, these will expire on a Friday.
Please note that the third Friday of each month is the day most options expire. On this day most buyers and sellers (whether it be institutions, banks, or others) will conclude their contracts. It’s also the day that generally contains the most competitive option pricing.
If you haven’t exercised the option by the expiration date, the options contract becomes worthless, and the premium paid for the option stays with the option seller. As time marches on, for the option buyer, his or her option becomes worth less and less with each passing day. For the Option Seller, his or her position will increase in value with the passage of time.
TIME DECAY OF OPTIONS
Values for options that are purchased, both CALL and PUT options, decrease over time primarily due to a concept known as time decay. Options are wasting assets, meaning they have a finite lifespan. As the expiration date of an option approaches, the time value of the option decreases because there is less time for the underlying stock to move in a way that would make the option profitable. The value of an option is composed of intrinsic value and extrinsic value (time value). As time passes, the extrinsic value diminishes, especially if the stock price remains stable or moves unfavorably for the option holder.
In summary, as the expiration date nears, the opportunity for the underlying stock to move in a favorable direction for the option holder decreases, leading to a reduction in the option’s value. This is a natural characteristic of options and is an important consideration for traders and investors when managing their options positions.
STRIKE PRICE
The strike price is the agreed-upon price at which the asset can be bought or sold if the option is exercised. For example, when you own a call option, and the strike price is below the current market price, the seller of the option has agreed to sell you that stock at the strike price so technically you could buy the stock for that price strike price, which is lower than the current market price, for a quick win. The more time there is before an option expires, the more valuable it is. Options that are sold gain value as the expiration date gets closer. Always remember, options are wasting assets.
IN THE MONEY (“ITM”)
CALL options are considered “in the money” when the current price of the underlying asset is higher than the option’s strike price. This means the option has intrinsic value because you can buy the asset at a lower price than the market price.
PUT options are considered “in the money” when the current price of the underlying asset is lower than the option’s strike price. This gives the option intrinsic value because you can sell the asset at a higher price than the market price.
OUT OF THE MONEY (“OTM”)
CALL options are considered “out of the money” when the current price of the underlying asset is lower than the option’s strike price. In this case, the option has no intrinsic value because buying the asset at the strike price would be more expensive than buying it at the market price. PUT options are considered “out of the money” when the current price of the underlying asset is higher than the option’s strike price. Here, the option has no intrinsic value because selling the asset at the strike price would be less profitable than selling it at the market price.
PREMIUMS
Premiums are fees paid by the option buyer to the option seller when they enter an options contract.
LEVERAGE
Options trading also offers a smaller financial commitment with potentially higher returns. This is because options allow you to control a larger amount of stock with a relatively small investment – the premium. If the stock moves in your favor, the percentage return on the premium can be substantial. However, if the market doesn’t move as expected, your only loss is the premium paid, making it a calculated risk with a clear maximum loss.
AMERICAN VS EUROPEAN STYLE OPTIONS
There are different option types primarily known as European and American style options. American options can be exercised at any time before expiration, while European options can only be exercised on the expiration date. As an example, for an American PUT option the option buyer can assign their stock before expiration once the price falls below the strike price. Conversely, with an American Style option, the Option BUYER can purchase the stock once it hits the Strike Price ahead of the expiration date. American options typically having higher premiums due to their flexibility and being more common for individual stocks, while European options, often used for indices, are generally cheaper and have cash settlements.
OPTION TRADING ORDER TYPES
With Options, you are either a BUYER or a SELLER. Your strategy will be different depending on the decision you make to buy or sell. How you approach the market will also change based on your core strategy. There are four types of Options orders:
- Buy to Open
- Buy to Close
- Sell to Open
- Sell to Close
OPTION BUYER
If you are a BUYER of Options then you have two methods to buy an option (a) BUYING A CALL – hoping the price will increase which will put money in your pocket if you close in profit OR (b) BUYING A PUT – hoping the price of the option (via the underlying security) will go down which you can profit from when you close. You can make money either way.
Buy to Open means you are paying a premium to the owner of the stock in anticipation that the stock price will go up.
Buy to Close means you sold an option and there comes a time when you wish to close out that trade, so you are Buying to Close.
Buying CALLS or PUTS can be expensive. Selling option contracts does not have the same high potential for returns but does offer steady income and consistent returns.
For the retiree selling PUT Options it is an excellent strategy to consider. The other very real challenge of being a Buyer is that the option itself becomes worth-less and less with the passage of time (known as time decay discussed above). If the market doesn’t do what you think it will do, within a certain time, then your option contract decreases in value with the passing of time even if the stock price itself does not move much.
OPTION SELLER
If you are a SELLER of Options you have two order types (a) SELLING A CALL – called a “covered call” where you own 100 shares of the underlying stock OR (b) SELLING A PUT – in which you are agreeing to buy 100 shares of stock if it hits a certain STRIKE PRICE prior to expiration.
Some brokers allow you to sell “naked calls” where you don’t own the underlying stock but are agreeing to purchase the stock at the strike price should you need to deliver the stock to fulfill your obligation.
Sell to Open is where you select a contract expiration date and a strike price that you are agreeing to buy the stock for, should the buyer of the option wish to exercise the option at the contract expiration date. If stock price is above the strike price when the contract concludes then as a Seller you have no further obligation.
Sell to Close is appliable where you bought an Option originally, the price went up or down, then comes the time when you wish to close the trade. You are selling to close to trade where you purchase the option at the option price at that time.
When you sell a CALL or PUT, you receive a “premium” upfront from the buyer for this transaction. The premium is deposited into your account and shows up instantly as a credit. For each contract where you are selling a call, you must own 100 shares of that stock.
When selling a PUT, you are simply committing to buying 100 shares of that stock, for every PUT contracts you sell, should the price fall below your strike price. Unlike selling call options, PUT selling does not require ownership of the asset. What you are selling is your commitment to buying that stock should the price fall below the strike price.
As a Seller of Options, you can close the contract out prior to expiration and walk away with your profits and no further obligation. As a Seller, unlike a Buyer, time is working in your favor. As time marches on, as a Seller, your position becomes stronger.
As the value of the security rises the value of your PUT rises and you can bank the profits. PUT sellers have an advantage over PUT buyers because of time decay even though the amount of money PUT SELLERS can make is potentially less. One advantage for PUT sellers are more data points for a Seller to consider. Why? Because you can see where price has reacted in the past. Whereas a Buyer of options destiny is a little less certain. Everyone will develop their own strategy on whether they prefer to be an OPTION BUYER OR SELLER.
In my opinion, PUT Selling is the best option strategy as it gives the PUT Seller many ways to be successful. Everyone has their own opinion on trading strategies but whatever your opinion is, it simply needs to work for you.
SUMMARY
There are many moving parts to option trading and frankly it is easy to get confused. Before you begin setting strategies and start trading you really do need to understand the fundamentals. Time decay (Theta) is one of the most important concepts to get your mind wrapped around. It is a lot to digest so before you get started, immerse yourself in understanding the fundamentals to prepare yourself for the journey that lies ahead.