Back to Option's Basics

In recent articles, we’ve gone down some pretty esoteric paths. Those articles are of interest mainly to experienced option traders. For the next few articles, I’ll go back to the basics. If you are a new option trader, or interested in seeing what option trading has to offer, these will be for you.

Short articles like this are not going to take you from zero to amazing as an option trader. For that, you need serious education, like the kind that Online Trading Academy offers in our regular classes. But I can give you a taste of what the option market is like.

First let’s define what options are. For our purposes, options are trading instruments that can be bought and sold using online trading platforms, through organized options exchanges. They are things that we can buy low and sell high. In this way, they are like stocks.

Options, however, have some unique characteristics that are decidedly “un-stock-like”. These special characteristics mean that options give us opportunities that we do not have with any other trading instrument. We can, for example, make money from a stock that stands still, even if it pays no dividends. We can also use the leverage built into options to make large profits on small investments if we do it right. Or we can use options to protect a portfolio if we fear a market crash.

Continuing with our definitions:

Each option trading unit is a contract, with two contracting parties. The two parties are the buyer of the contract, and the seller of the contract (also called the writer). The contract gives both rights and obligations to each of the two parties. In the U.S., those rights and obligations are enforced by a central clearing house serving several regional options exchanges.

Every option is based on an underlying asset, from which it derives its value. This is why options are called derivatives. Some of the types of assets that have listed options are stocks, exchange-traded funds, futures contracts, and indexes. In these articles, we’ll concentrate mainly on options on stocks and exchange-traded funds. That is, we’ll talk about options on things that you can trade in a regular stock brokerage account.

There are two, and only two, distinct types of options.

Call options give the person who owns them:

- the right to buy a fixed quantity (usually 100 shares) of the underlying asset

- at a specific price, called the strike price

- on or before a certain date, called the expiration date.

Call options resemble a coupon that says, for example: “Present this coupon plus $8700 for 100 shares of QQQ. Offer expires May 16, 2014.” The coupon (option) is fully transferable and can be sold to another person at any time until it expires.

The person who holds that coupon, which would be referred to as the May 87 call option, can “turn it in” with $8700 (exercise the option) on or before the close of business on May 16, and receive 100 shares of QQQ. If by that time QQQ is at say, $90, then the option will have $3 worth of value. If the option buyer paid less for it than that $3, then it will have been profitable.

The second type of option is the put option.

Put options give the person who owns them:

- the right to sell a fixed quantity (usually 100 shares) of the underlying asset

- at a specific price, called the strike price

- on or before a certain date, called the expiration date.

Put options resemble insurance policies. A put option on QQQ, at the same $87 strike as the call in the above example, would give the put owner the right to sell 100 shares of QQQ at $87 any time up to the expiration date. If you owned 100 shares of QQQ and wanted to insure yourself against a loss, you could buy a put option. If QQQ then did drop, say to $80 per share, you could “make a claim” (exercise the put option) by surrendering the 100 shares of QQQ and receiving $87 per share. Your cost to do this will be the price you paid for the put option. The money paid for any option, in fact, is referred to as the premium for the option.

Note that you do not have to own the QQQ to buy put options. Anyone who owns puts has the right to sell the underlying asset – whether they own that asset or not. Since puts are freely transferable, they go up in value as the price of the underlying asset declines. The right to sell QQQ at $87 is valuable, if QQQ is selling for $80. Whoever has that right could buy QQQ on the open market for $80, and then exercise the put option and thereby sell QQQ at $87. That right is worth at least $7 ($87 – $80). If there is some time to go before the option expires, it will be worth more than $7. That is because QQQ could go even lower. In that case, the right to sell it at $87 would be worth even more. Because of that possibility, the option will sell for some amount over $7. In future articles we’ll talk about how much larger that amount can be, and what affects it.

Being able to buy put options on a stock you don’t own is kind of like being able to buy insurance on somebody else’s car. If the car is damaged, the insurance company pays you. If not, they don’t. You would of course want to buy insurance on the car of someone you think is a very bad driver, and therefore likely to damage the car. In the same way, you can buy put options on stocks that you think are likely to suffer damage (go down in price).

With both calls and puts, there is a right to buy the underlying asset (calls) or to sell it (puts) at a fixed price. Those rights are potentially very valuable. If the options do become profitable to the buyers, where does the money for their profit come from? The answer is that it comes from the sellers of the options. I mentioned above that the option contract confers both rights and obligations on both parties.

The right of the call seller is to be paid for the call immediately on entering the transaction.

The obligation of the call buyer is to pay for the call when it is purchased.

Once the contract has been sold to the buyer, then the call buyer has the right to buy the stock at the strike price.

The call seller has the obligation to sell the stock at the strike price, if the call buyer demands it.

Similarly for puts:

The right of the put seller is to be paid for the put immediately on entering the transaction.

The obligation of the put buyer is to pay for the put when it is purchased.

Once the contract has been sold to the buyer, then the put buyer has the right to sell the stock at the strike price.

The put seller has the obligation to buy the stock at the strike price, if the put buyer demands it.

As mentioned above, these rights and obligations are enforced by a central clearing organization, called the Options Clearing Corp. (OCC). The OCC moves the cash between the brokerage accounts of the option buyers and sellers, and later moves the stock between them if need be. The OCC guarantees every option buyer’s rights, so that the buyers can be sure they will be able to collect their profit if and when it materializes.

That’s all we have space for today. In later articles, we’ll explain more about the use of options, and the many ways in which we can use them to make money.

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