INTRODUCTION TO OPTIONS - GENERAL CONCEPTS AND OVERVIEW
A Few Questions to Get the Conversation Started - General Concepts:
Options trading can serve as a powerful means in generating income and accentuating portfolio returns. This can be done in a risk-defined manner via leveraging small amounts of capital to maximize return on investment.
Technically, an option is a contract which gives the buyer (paying out a premium) of the contract the right, but not the obligation, to buy or sell the stock of interest at a specified price on or before a specified date. The seller (receiving a premium) of the option has the obligation to buy or sell the stock of interest if the buyer exercises the option contract. An option that gives the buyer the right to buy the stock at a specific price is referred to as a call (bullish); an option that gives the right of the owner to sell the security at a specific price is referred to as a put (bearish).
Types of Options Explained (Calls and Puts):
Bullish (call) can be simply stated as when one believes a stock will rise in the future. As opposed to buying the underlying security, one can execute this bullish sentiment via the options market. There are two ways to exercise this bullish stance via options. Under this bullish narrative he can buy a call option to have the right to purchase the stock at a later date for an agreed upon price while paying a premium for that right to buy shares. Here the option buyer believes the shares will increase in the future and doesn't mind paying a premium to have the right to buy the shares in the future. If shares do not appreciate beyond the price that was agreed upon (strike price) then the option buyer cannot exercise (buy the shares) the option and relinquishes the premium paid to the option seller.
Alternatively, he can sell a put option to take on the obligation to purchase the shares at a later date for an agreed upon price while being paid a premium. Here, the option seller receives a premium to take on the risk of potentially being assigned shares. However, the option seller believes the shares will increase not decrease thus he's willing to receive a premium in exchange for potentially being assigned shares betting the shares will not move below the strike price throughout the option life cycle. If the shares remain above the agreed upon price (strike price) then the put seller keeps the premium and is not assigned shares while the option buyer relinquishes the premium. This is consistent with being bullish, betting that shares do not decrease below a certain level and appreciate over time.
In both cases, he/she believes that the shares will rise significantly. In the first scenario, he/she is buying the call option to have the right to buy the shares at $105 a month from now when the current price is $100. The buyer believes the stock will rise past $105 and thus be able to buy the shares for $105 (less the premium paid for the option contract) when shares may be worth much more than $105 a month from now.
In the second scenario, the option seller is taking on the obligation to buy the shares at $95 a month from now when the current price is $100. The seller of the put contract believes the shares will remain above the $95 level through the option life cycle. Thus the owner of the shares would not be able to exercise the option and assign shares to the put seller if the shares remain above the strike price of $95 and remain out-of-the money. In this case, the put option seller collects a premium from the put option buyer and still makes money without owning any shares via premium income .
Conversely, bearish (put) can be simply stated as when one believes a stock will fall in the future. Thus he can exercise this bearish sentiment via the options market. He can sell a call option which forces the obligation to sell the stock at an agreed upon price by an agreed upon date while collecting a premium. Here the call seller believes that the stock will not appreciate beyond the agreed upon price by the agreed upon date, consistent with being bearish since the bet is against the shares appreciating beyond a certain level. If shares do not appreciate beyond the strike price then the option seller will not be forced to relinquish shares and keep the premium in the process.
Alternatively, he can buy a put option to have the right to sell the shares. In this case the option buyer believes the stock will decrease in the future, consistent with being bearish. Here the option buyer will pay a premium to have the right to sell shares betting that shares will be lower than the agreed upon price by the agreed upon date thus can sell shares to the option seller at a higher price than the market price if the shares fall in value beyond the strike price.
In both cases, he believes that the shares will fall significantly. In the first scenario, he is selling the call option to take on the obligation to sell the shares at $105 a month from now when the current price is $100. The seller believes the stock will fall or stay below the $105 level and thus be able to keep the shares and the premium paid for the option contract assuming the shares stay below the $105 level. In the second scenario, he is buying the right to sell the shares at $95 a month from now when the current price is $100. The buyer of the put contract believes the shares will fall below the $95 level. Thus the owner of the shares would exercise the option and assign shares to the put seller if the shares fall below $95. Why sell the shares below $95 on the open market when the owner can sell them to the put seller for $95? When buying a put option, it is effectively an insurance policy against the shares falling. In this case, the put option seller collects a premium from the put option buyer and may be assigned shares at a higher price than the market price as a result of the shares falling.
The key here is that there's premium being exchanged and being a net options seller is the main component to successful options trading.
On this website, I focus on selling options only, specifically more sophisticated trade structuring such as put spreads, diagonal put spreads and iron condors. Essentially betting that shares will rise, trade sideways or even marginally down without going below the strike price while being paid a premium net premium in the process.
A Few Characteristics of Options Trading:
1. Strike price: For call contracts - Price at which you can buy the stock (buyer of the call option) or the price at which you must sell your stock (seller of the call option). For put contracts - Price at which you must buy the stock (seller of the put option) or the price at which you can sell the stock (put buyer).
2. Expiration date: Date on which the option expires
3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.
4. Time premium: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility the greater the time premium received.
5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration, the option will increase in lock-step.
Time and Intrinsic Variables:
The two variables that provide option contacts with value are time and intrinsic worth. The more time that is built into the contract the greater the value of the contract. This is especially true for volatile stocks or in periods of volatility. The intrinsic value is how much the stock is actually worth on the open market. In the case of a covered call, if a stock is currently worth $95 and has a one month contract at a strike of $100 with an option price of $2.00 then both variables come into play as the stock moves. In this case, as the expiration of the contract approaches, the time factor erodes away and the value of the option decreases as a function of time if the underlying stock remains below the strike price of $100. As the price of the stock moves above the $100 strike price the option contract will rise in lock-step beyond the strike price and increase the value of the contract translating into intrinsic value. Conversely, as the underlying stock falls in value and away from the strike price this will decrease the value of the contract since it's more unlikely that the shares will reach its strike price. As expiration approaches and the stock doesn't appreciate, the time and intrinsic values will evaporate and the option becomes worthless and expires.