What are Options?
Options are financial vehicles used to buy and sell securities such as stocks before or at a particular point in time. Options can also be used to buy and sell other type of securities, such as ETFs, indexes, and currencies. Options are derivatives, meaning, the options price is based off the price of another security, such as a stock, ETF, or Index.
Lets take a look at the 7 components of an option order.
sell 1 abc July 30, 30x put $1.50
- buy or sell
- number of contracts
- underlying security ticker
- expiration date
- strike price
- put or call
- premium
The 1st component represents the action taken by the investor. That action can be either the buy side or sell side of the transaction.
The 2nd component is the number of contracts traded. 1 contract equals and controls 100 shares of the stock or security.
The 3rd component is the stock or security that is involved in the transaction.
The 4th component is the expiration date
The 5th component is the strike price that is chosen by the investor. This is the price that the investor is willing to buy or sell the stock or security in the future.
The 6th component is a put option or call option.
The 7th component is the premium. Premium is another way of saying the price of the option contract. Buyer spend this amount, sellers receive the premium amount.
Buying Calls
Strategy 1 - buy 1 abc July 30, 30 strike call .50 cents
- strategy | selling covered calls
- money spent | $50 (.50 x 100 shares)
- current stock price | 29
- expiration | 1month
- degree of risk | very high
- market outlook | bullish – investor wants the stock to go up
the strategy | Buying calls is a very risky strategy. Most investors should avoid this strategy. Call buyers are bullish, they want the stock to go up in price in order for their options to increase in value.
In this example, the buyer of this call option spent $50 since the price of the call option was .50 cents. This buyer wants to sell the call option at higher price than what the contract was bought for.
These contracts expire and stop trading at the close of business on July 30th. The contracts can be sold early, before expiration or at expiration. If abc stock closes on expiration at $31 a share, then the price of the option would be priced at $1, since the actual stock price is 1 point higher than the $30 strike price which was selected by this investor.
The call option went up in value since the abc stock went up in value, thus the investor can sell the option for a .50 cents profit on the option, which equates to a $50 profit to the investor. If the stock closes below $30 upon expiry, then the price of the option would go to 0. The investor would lose his total investment of $50.
Buying Puts
strategy 2 | buy 2 abc January 30, 40 strike puts 30 cents
- strategy | buying calls
- money spent | $50 (.50 x 100 shares)
- current stock price | 31
- expiration | 1 month
- degree of risk | very high
- market outlook | bearish – investor wants the stock to go down
Buying puts is also a very risky strategy because you can quickly lose your entire investment. Put buyers are bearish on the stock. They want the stock to go down in price in order for their options to increase in value.
The buyer of the 2 put options spent $100 since the price of the 2 put options were $50. This buyer wants to sell the put option at a higher price than what the contract was bought for. These contracts expire and stop trading at the close of business on January 30th.
The contracts can be sold early, before expiration or at expiration. If abc stock closes on expiration at $28 a share, then the price of the option would be priced at $2, since the actual stock price is 2 points lower than the $30 strike price which was selected by this investor.
The put option went up in value since the abc stock itself went down in value, thus the investor can sell the option for a $1.50 profit on the option, which equates to a $300 profit to the investor.
If the stock doesnt close below $30, the put buyer would lose the entire investment of $100 if the puts were held til the expiry date of January 30th.
Selling Cash Secured Puts
strategy 3 | sell 5 abc May 30, 35 strike puts $1.30
- the strategy | selling cash secured puts
- premium received | $650
- current stock price | 36
- expiration | 1 month
- degree of risk | low for professional traders, medium for amateur traders
- market outlook |
Puts sellers are neutral to bullish on the stock. Puts are sold to buy stock at a particular price. Premium is collected by the put seller. The seller of the 1 put option receives $650 since the price of the put option is $1.30. (5 contracts)($1.30 option price) = $650.
Put selling is another way investors can buy stock. In this example, the stock was trading in the open market at $36 a share. The investor sells a 35 strike put for May 30th, which is when the contracts expire and stop trading.
If the stock closes at any price level below $35, then put seller will automatically buy the stock the following business day, which is usually a Monday at $35 a share. If the stock closes at $35 or above, then the put seller will not buy the stock.
Either way, the investor gets to keep the $100 premium just from selling this potential future obligation.
The contracts can be closed early, this is done by buying the contracts back in the open market, before expiration or at expiration, hopefully at a lower price than what the contract were originally sold for.
Selling Covered Calls
strategy 4 | buy 500 shares abc stock at $40 |
sell 5 abc October 30, 41 strike calls at $1.10
- the strategy | selling covered calls
- money spent to buy stock | $20000
- premium received | $550
- current stock price | $40
- expiration | 1 month
- degree of risk | low for professional traders, medium for amateur traders
- market outlook
Covered Call Sellers are neutral to bullish on the stock. Covered calls are sold as an exit strategy, to sell existing shares at a particular price. the seller of the 5 call options receives $550, since the price of the call option is $1.10.
Covered call selling is another way investors, can sell their existing shares. In this example, the stock was trading in the open market at $30 a share. The investor buys 100 shares of abc stock, in the open market at $30 a share. The investor sells a 41 strike call for October.
If the stock closes at any price level above $41, then the shares will automatically be sold at $41, the following business day, which is usually a Monday. If the stock closes at $41 or below, then the call seller will not sell the stock.
Either way, the investor gets to keep the $550 premium just from selling this potential future obligation. The contracts can, be bought early, this is done by buying the contracts back in the open market, before expiration.