Learning the basics of options

 Learning the basics of options involves three steps:

1. Understand the rights and obligations of long and short

options,

2. Learn to calculate profit and loss at expiration, and

3. Master the mechanics of exercise and assignment.

How to Draw Profit and Loss Diagrams

How to Draw Profit and Loss Diagrams

Strategy: Long Call EXAMPLE: Buy a 50 Call @ $2

Call Options vs. Put Options

A call option gives you the right to buy an underlying stock at a specified strike price, on or before an expiration date. Conversely, a put option gives you the right to sell an underlying stock at a pre-determined strike price on or before the specified expiration date. When you buy 1 call option or 1 put option, you pay a premium to receive the right to buy or sell 100 shares of an underlying stock

That said, the amount of premium you paid is the maximum amount you could lose. However, if you hold an options contract and it expires “in the money” you would be automatically exercised on that option. Therefore, you need to make sure you have enough capital in your account to buy or sell shares of the underlying if you plan on holding options until the expiration date. Generally, we will exit our positions before the expiration because we don’t want to take the risk of buying or selling the stock when we’ve already taken large profits or small losses on the options trades. 

In order to receive the right, but not the obligation, to buy or sell the underlying stock at a specified price any time on or before the expiration date, the owner pays the seller, or writer, the option premium. If you buy a call option, and the underlying stock increase significantly, the owner of the call option would have unrealized profits. On the other hand, the writer of the call option would suffer. Now, the writer of an options contract takes the opposite side of risk and receives a premium.

 However, the writer of an options contract is obligated to deliver shares of the security if they are exercised, or if the options contract expires in the money

Keep in mind that naked writing options, or selling without hedging the options, is extremely risky. You shouldn’t look to write options when you’re first starting out. Moreover, you’re going to need some collateral if you’re looking to write options to collect premiums. 

Now, let’s assume you saw Apple Inc. (AAPL) report strong earnings and you thought once it broke above $200, it could continue higher. You decide to buy 1 AAPL 17 AUG 18 200 Call. That means you’re buying 1 call option contract on AAPL expiring on August 17. Well, you could see that it’s $3.95 bid x $4 ask, and you’re willing to pay the nickel spread and you take the ask, or

 offer, at $4. That means you spent $400 on the option contract. If AAPL closes below $200, you would lose your premium. However, if it gets to $210, theoretically, your option would be worth at least $10. 

 profit and loss at expiration, depending on where the stock is trading in relation to the strike price. In this example, you wouldn’t start making money until AAPL broke above $204. Why’s that? Remember how you already paid for the options. That money is already spent, but that doesn’t mean you can’t sell it and take a small loss, rather than your entire premium if the stock isn’t going your way. Again, if AAPL closed below $200 on August 17 (the expiration date), you would lose your entire premium if you held onto them.

Assume a trader was actually bearish on AAPL and believed it would pull back once it reached $200. Well, if the stock actually closed below $196, he would make money. The trader paid $400 for one $200 strike price put option on AAPL. If AAPL actually closed above $200, their option would be worthless. You should have a basic understanding of the difference between call options and put options. Before we start looking at ways to use put options, you’ll need to understand how options are priced. 

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How Options Are Priced

Now, there are three major factors affecting stock option prices:

● The underlying stock’s price 

● Time to expiration date 

● Volatility The “less” important factors affecting options prices: 

● Short-term interest rates 

● Dividends

 Keep in mind that interest rates would matter if they’re constantly changing. 

That said, let’s take a look at how these factors affect an option’s price.

Time Value and Expiration When there is a lot of time remaining until the option’s expiration date, the premium would be higher. In other words, an option with six months until its expiration date would have a higher premium than one with one month until expiration, all else being equal. 

Volatility 

Volatility is the underlying stock’s tendency to fluctuate in price. This means volatility reflects the price change’s magnitude and does not have a bias toward price movement in one direction or another. You need to understand that the higher the volatility, the higher the option premium should be. The lower the volatility, the lower the premium.

 Interest Rates Generally, interest rates do not affect premiums as much as the time value, the underlying stock price, and volatility. However, when interest rates experience a high degree of fluctuations, rates matter. An increase in interest rates typically increases call prices and decreases put prices, based on the famous Black-Scholes pricing model. There are flaws with this model, but it’s an industry standard. However, we won’t get into all the details of this pricing model.

 Dividends Options are often priced assuming they would only be exercised on the expiration date. That means if a stock issues a dividend, the call options could be discounted by as much as the dividend amount. However, put options would be more expensive since the stock price should drop by the dividend amount after the ex-dividend date. Before you move on, you should clearly understand these factors and how they affect option prices. Next, we’re going to look at an extremely important topic: intrinsic and extrinsic value.

Intrinsic and Extrinsic Value An option’s value is comprised of two components: intrinsic and extrinsic value. The intrinsic value simply tells us the amount an option should be worth when comparing the underlying stock’s price and the strike price. Let’s use the Apple (AAPL) example from earlier. Apple was trading around $200 and assume you bought 1 call option expiring in two weeks. The options give you the right to buy the stock at $200. Assume Apple ran to $210 and there’s still one week until the expiration date. That said, your option should be worth at least $10, or $1,000.

, intrinsic value is the value that an in-the-money option must have by being ITM. That means an option must be worth as much as the difference between the strike price and the underlying stock price.