Options Basics Part One
Okay, so this is going to be a very basic description of what options are about. An option is the right to buy or sell a set number of shares of stock at a certain price which is called “the strike price.” There are calls and there are puts. First we’ll talk about just buying options because it’s simpler. So if you buy a call, for every contract you buy, you have the right to purchase 100 shares of stock at a set price which is whatever the strike price of the option is, by a certain time, which is whatever the expiration date of the option is.
So let’s choose IBM and let’s say it’s going for $100 per share. If you buy a call option, with a 105 strike a month out, that means that you have the right to buy 100 shares of IBM at $105 for each option contract anytime up until the expiration date which is one month out.
Now, if you are buying a put that means you have the right to sell the stock at a certain strike price within a certain time frame. So let’s say IBM is at 100 and you buy one put contract at $95 strike price for a month out. What that means is that you have the right to sell 100 shares of IBM per contract at $95 per share, anytime between now and a month from now. And for that right, you’re going to be paying the option premium and that goes both for calls and puts. If IBM is not a very volatile stock then the premium is going to be smaller. If you’re trading a different stock like Tesla or Netflix for instance, the premium is going to be higher and the reason for that is pretty simple. It’s that there’s a bigger likelihood that the stock is going to be above or below the strike at some time between now and the time the option expires.
So let’s go over that again, calls give you the right to call away the stock from somebody. In other words, buy the stock at a certain strike price within a certain time frame. Puts give you the right to put the stock to somebody. In other words, sell the stock to somebody at a certain strike price within a certain time frame.
Buying options is the simplest way to go and a lot of times the best way to go. When you buy, you’ll be paying a premium, but you’re in total control. You know what your maximum loss is… it’s the cost of the contract and your possible profit is usually much greater than your possible loss.
Some people sell options and you might have heard that that’s a really good way to go, but we’ll get into that later… it’s definitely more risky. If you do sell options then you collect the premium up front rather than paying it. When selling calls, if the stock does not get equal to or above the strike price, or in the case of puts if the stock does not get equal to or below the strike price, then you collect the entire premium and the option expires worthless. If the price of the stock is between the strike price and the strike price plus the premium amount you will keep a portion of the premium.
If the option ends up above the strike price it’s what’s considered in the money and you will either have to deliver the stock to the person that you sold the option to or cover the option by buying back a call or buying back a put or as many puts or calls as you sold.
Okay, so that’s the simple basic description of what options are about and in other blog posts I’m going to go into more detail.