Clearing Up Some Confusion About Options
Wow!
Thank you to everyone who’s written in over the past few weeks!
I’ve received some fantastic feedback on our options series so far. And I’m thrilled to hear that several Money Talks readers are already having success with their new CoPilot by TradeSmith tools.
But I’ve also heard from some options “newbies” who are still a little confused about how they work.
So, before we dive into some of the details of successful options trading (with or without a CoPilot subscription), I want to take a step back and review the basics one more time.
By the end of today’s essay, I want every Money Talks reader to understand four key ideas:
- Exactly what an option is
- The differences between the two types of options
- The differences between buying an option (a “long” options trade) and selling an option (a “short” options trade)
- The potential risks and rewards of these four primary options trades
Sound good? Alright, let’s jump in…
What is an Option?
In simple terms, an option is just a contract that trades on the open market. And these contracts have three main characteristics.
First, each options contract grants the person who owns it the right, but not the obligation, to buy or sell a specific stock or fund (known as the “underlying” stock) at an agreed-upon price (known as the “strike price”) on or before an agreed-upon date (known as the “expiration date”).
Second, each options contract represents or “controls” precisely 100 shares of the underlying stock or fund.
And third, each options contract has a market price or value known as its “premium.” That is the cost the buyer must pay to be entitled to the rights of the contract.
The premium is mathematically determined by a combination of the price of the underlying stock relative to the strike price, the volatility of the underlying stock, and the remaining time until expiration.
The Two Types of Options
There are two basic types of options: call options and put options.
The main difference between these two types is whether they grant the contract holder the right to buy or sell shares of the underlying stock.
A CALL option is a contract that grants the HOLDER the RIGHT TO BUY 100 shares of the underlying stock at the strike price on or before the expiration date.
That generally makes buying a call option a bullish bet on the underlying stock.
For example, a call option on Apple (AAPL) with a $150 strike price and an expiration date of Aug. 20, 2021, grants the holder the right to buy 100 shares of AAPL at, you guessed it, $150 per share on or before Aug. 20.
If shares of AAPL rise to $160 by Aug. 20, the holder could theoretically “exercise” the option and buy shares at $150, then immediately turn around and sell them for $160, and pocket $10 per share. And the higher AAPL shares rise above $150, the more money the holder will make.
(I say theoretically because the option premium — the price of the options contract — will automatically reflect this increased value, so most holders will simply sell the options contract before expiration rather than exercise it.)
On the other hand, a PUT option is a contract that grants the HOLDER the RIGHT TO SELL 100 shares of the underlying stock at the strike price on or before the expiration date.
That makes buying a put option a bearish bet on the underlying stock.
The holder of a put option will generally profit if the underlying price falls below the strike price by expiration. And the further below the strike price it falls, the greater the potential profit that the holder will earn.
There are a few important points here…
First, whenever you buy an option — whether it’s a call or a put — your goal is the same: you want the value of that options contract to rise.
The main difference between calls and puts is what the underlying stock’s price must do to cause the option’s value to rise.
When you buy a call option, you need the underlying stock’s price to RISE above the strike price to cause the value of the option to rise.
When you buy a put option, you need the underlying stock’s price to FALL below the strike price to cause the option’s value to rise.
Second, when buying either calls or puts, the risk-to-reward profile is similar.
On the risk side, if you’re wrong about the price movement of the underlying stock, the most you can lose is the premium you paid to buy the option.
On the reward side, if you’re right about the price movement of the underlying stock, there is no limit to your profit potential. The higher the price of the underlying stock rises (for calls) or the lower the price of the underlying stock falls (for puts), the more money you can make.
Third, while buying calls and puts carries limited downside risk and potentially unlimited upside, the likelihood of making a profit on any single trade is generally not much better than a coin flip. Most options end up expiring worthless.
By the way, the option type — as well as the general information I mentioned earlier — is included in the ticker for each options contract. For example, here’s the ticker for the Apple call option I mentioned earlier:
AAPL210820C00150000
“AAPL,” as you can probably guess, tells us this option controls shares of Apple (AAPL).
“210820” is the expiration date: 21-08-20, or Aug. 20, 2021.
“C” stands for “call option.”
And “00150000” stands for the $150 strike price. (The last three zeroes represent decimal places, so you can generally ignore them.)
Buying Options versus Selling Options
OK, so now we’re clear about what an option is, and we understand the differences between calls and puts.
Next, we’ll cover another idea that often trips folks up: selling options.
You see, because an options contract grants a specific set of rights to the holder (buyer), by definition, it also gives a specific set of obligations to the seller.
Selling an option (also known as “writing” an option) is like shorting a stock. If the value of that option falls before you buy it back or it expires, you get to keep the difference as profit.
That essentially makes selling a call or put the opposite bet of buying a call or put, respectively.
Again, let’s look at each of these options types separately.
Earlier, we saw that a CALL option is a contract that grants the HOLDER the RIGHT TO BUY 100 shares of the underlying stock at the strike price on or before the expiration date.
That makes buying a call a bullish bet on the price of the underlying stock.
When selling a call option, this proposition gets flipped on its head.
Specifically, a CALL option grants the SELLER the potential OBLIGATION TO SELL 100 shares of the underlying stock at the strike price on or before the expiration date. In exchange for this risk, the call seller receives the premium (the option’s price) as an up-front payment.
That generally makes selling a call a bearish (or neutral) bet on the underlying stock.
For example, suppose we sold that same AAPL call option with a $150 strike price and an expiration date of Aug. 20. At current prices, we’d receive around $350 in premium for doing so.
With AAPL shares currently trading around $146, we would profit from this trade if shares fall, stay the same, or even rise a little.
So long as AAPL stays below $150 by expiration, the option will expire worthless, and we’ll get to keep the entire premium as profit. And we wouldn’t lose money unless AAPL shares rose above $153.50 or so by expiration (the strike price plus the value of the premium we collected).
It works the same way when selling put options…
As I mentioned before, a PUT option is a contract that grants the HOLDER the RIGHT TO SELL 100 shares of the underlying stock at the strike price on or before the expiration date.
Again, that makes buying a put option a bearish bet on the underlying stock.
Flipping this on its head means a PUT option grants the SELLER the potential OBLIGATION TO BUY 100 shares of the underlying stock at the strike price on or before the expiration date. In exchange for this risk, the put seller receives the premium (the option’s price) as an up-front payment.
That generally makes selling a put a bullish (or neutral) bet on the underlying stock.
Just as we saw with buying options, there are a few critical ideas you need to understand here.
First, whenever you sell an option — whether it’s a call or a put — your goal is the same: you want the value of that options contract to fall.
But again, the main difference between calls and puts is what the underlying stock’s price must do to cause the value of that options contract to fall.
When you sell a call option, you generally need the underlying stock’s price to STAY BELOW the strike price to cause the value of the options contract to FALL.
When you sell a put option, you need the underlying stock’s price to STAY ABOVE the strike price to cause the value of the options contract to FALL.
Second, when selling either calls or puts, the risk-to-reward profile is also similar.
On the reward side, your maximum profit is the premium you collect up-front when selling the options contract. If you’re right about the price movement of the underlying stock, the contract will fall in value or expire worthless, and you get to keep some or all of the premium.
On the risk side, if you’re wrong about the price movement of the underlying stock, your potential losses can be significant.
Specifically, when selling a put, the underlying stock could theoretically fall to $0. In this worst-case scenario, your maximum loss would be equal to the strike price x 100 (the number of shares you’d be required to buy) — and what you just bought is literally worthless.
For example, when selling a put with a $10 strike price, your maximum loss would be $1,000 if the stock were to fall to $0 by expiration.
When selling a call, the stakes are even higher. Because there is theoretically no limit to how high a stock can rise, your maximum loss is potentially unlimited.
Now, in reality, the likelihood of any stock falling to $0 or rising to infinity in a short period is extremely low.
In most cases, the realistic maximum loss will be significantly less than the worst-case scenario. And you can reduce your risk further by choosing the right options contracts to sell and using stop-losses.
But you should be aware of these risks and how to manage them before selling any options contracts.
And finally, while selling options contracts carries greater risk and lower potential reward than buying options contracts, the probability of earning a profit is generally much higher. Because most options contracts end up expiring worthless, the odds are more often in favor of options sellers.
That’s it for today. I hope that clears up some confusion. Next week we’ll take a closer look at some specific options trades you can use to improve your investing.
In the meantime, if you have any questions or comments about today’s Money Talks, I’d love to hear from you. You can reach me at [email protected]. Please note, I can’t personally respond to every email, but I do read them all.