What is an Option? – Beginner Series

I tend to trade options pretty heavily in order to use leverage and not commit too much capital. Following up on my “what is a stock” article, I thought I would go over options again. I wrote an article explaining options before, but my writing style has evolved since then and so I thought I would revisit what is an option.

I am going to separate call options and put options into a different article. In order to embrace the beginner series I will mete out information in more digestible bits. When I try to cram in too many different concepts I get too far into tangents.

There are many advanced concepts I would love to talk about, but those will be under investing theory. Those articles will be amorphous hydras with a ton of information and a meandering approach. However, if you know the basics you will not find yourself lost.

Here I will define what an option is. In yet another article I will discuss buying options versus writing options.

An Option is a Contract

Fundamentally, an option is a contract. It is an agreement between two parties, call them A and B.

• Party A contracts with party B that party A will take a certain action regarding a stock at the will of party B
• The action will be taken at a specified price referred to as the strike price

• Party A’s obligation to party B will remain valid for a specified period of time after which it will expire
• In exchange for giving B this right, A will receive compensation

At the most basic level this describes the agreement embodied in a single option contract. In the scenario above it is party B who holds the option. Think of it like B having the contract, and when he decides he can go to A show him the agreement and make A do some action. This action varies depending on whether the contract is a call or a put.

I will go over this topic later, but will give the short version for the sake of clarity. If the contract is a call then B will purchase shares for a specified value, and A will be forced to sell at that specified value even if it is lower than the current market value of the share. If the contract is a put then B will sell shares to A for a specified value, and B will be forced to buy at that value even if the current market value per share is lower. I implore you to turn to the specific articles about calls and puts for more clarity.

Realities of Tradeable Options

The scenario I have laid out above describes an options contract as it would exist centuries ago, if there were corporations back then. When you and I trade options it takes place via an exchange. That is the noun of exchange, not the verb. An exchange is the equivalent of a marketplace for financial instruments.

The stock market is for shares of stock, and the options basically have their own exchange. There might not be a fancy name like NYSE or AMEX, but that is because options are derivatives of the financial instruments offered on the stock exchanges. Stay tuned for another article explaining stock exchanges.

Having a marketplace for options creates standardization and simplification of the process. In describing the contract process above you can see how difficult it would be if you had to draw up an agreement with a specific party every time you wanted an option. The exchanges simplify things and there are a few things to keep in mind.

• An option contract covers a potential transaction of an underlying security. Basically options exist for stocks and similar instruments like ETFs. That is why they are a type of derivative, because they derive from other financial instruments. You own a call/put on a specific stock like FB, IBM, GOOG, MSFT, XOM, etc.

• Expiration dates and strike values are set by market makers subject to regulation
• Different time periods for options include weekly, monthly, quarterly, and yearly
• Yearly options are referred to as LEAPS (Long Term Equity AnticiPation Security), which will be discussed in another article
• Types of options regarding quantity are standard for 100 shares, and mini for 10 shares
• Not all stocks have mini options
• Strikes come in various tiers such as 50 cent increments, $1 increments, or even $5 increments depending on the realities of specific stocks
• Clearing is done automatically, which means you do not have to go out and find a counter party to your contract. To simplify, if you are A, you do not have to go find B, because a market maker will find you a B through the exchange. From your perspective B is an abstract concept.
• Options contracts that are in-the-money (ITM) at expiry are assigned automatically by your brokerage. You must actively take steps to prevent this.
• There are two styles of options, American style and European style. American style options can be exercised by the options holder at any time. This is party B in the example in the first section. European style options can only be exercised at expiry, which means it occurs automatically on the day of expiry if they are ITM. Generally, everyone is talking about American style options with regards to American stocks and ETFs. Options on indices vary, but tend to be European. Note that SPY is an ETF that follows the S&P 500. I will always be talking about American style options, as will the vast majority of people.

Explaining Assignment and “…the-money”

When the right in the contract is actually exercised and a transaction takes place it is referred to as an assignment. The scenario gone over in the first section takes place.

For each individual standard contract that is in-the-money at expiry 100 shares changes hands. If you do not understand the preceding sentence read the bullet points again. I know that the bullet points are a bit dense, but its the reality of how options are trading. Learning it early and completely puts small details out-of-the-way. These are foundational concepts.

In-the-money (ITM) means that the price of the underlying security, i.e. stock, is on a certain side of the strike. In the case of calls the price of the stock is higher, and in the case of puts it is lower. Imagine your strike is at $10 for stock Y. For calls, the option would be ITM if Y was priced above $10. For puts, the option would be ITM if Y was priced below $10. Check the rules of your brokerages for specifics. Most brokerages say that if the stock is $0.01 ITM then the option will be assigned. I am not sure what happens if the stock closes right on the strike, but you understand the concept.

Out-of-the-money (OTM) means that the price of the underlying stock has not yet crossed the strike. Although if the stock is priced around the strike is it is usually called at-the-money (ATM). For example if Y is $9.98 when you have a call with a $10 strike it would be called at-the-money. Imagine if the next lower tier on the options chain was $9.50. That option is in-the-money, but a price of $9.98 is so close to $10 that it can be called at-the-money while the option is still valid. However, ATM means nothing with regard to rights regarding the option. It is a term of convenience, because ATM options tend to be more expensive than OTM options but cheaper than ITM options. Come expiry ATM means very little and 1 cent can determine OTM vs ITM. There is an actual definition of ATM, but I have not seen it used as strictly as the definition. The definition is just when the price and the strike price are equal.

Conceptually this is a bit difficult, but it is very important. You can buy options a lot cheaper than stock if it is OTM, but if they become ITM because the underlying stock makes a price movement you might be forced to make good on the transaction come expiry. Now you could avoid this by selling the option before expiry, but if you forget (don’t forget) then you would need to carry out the transaction.

If you have a call contract at a $10 strike and it is ITM at expiry you need to shell out $10 * (# of contracts * 100). For even 1 contract this would be $1000. You might be up on your position right away but you need $1000. Options traders might buy 10-20 contracts, and that would be $10,000-$20,000. Even if the position would be worth $50,000 after the transaction there might not be enough equity in the account to carry out the trade, which can be a problem. Rather than go over the problems, I will caution you to avoid assignment unless you actually want it to happen. In the case of puts you would need shares to deliver to the other party, which you would have to buy first on the open market. Even if they are cheaper than the contract price it can require a large amount of cash in your account to actually carry out the trade.

Role of Options

I trade options, but they do not exist as just another security I can trade like stocks. The concept behind options is about hedging, protection, and shifting risk. This is most obvious with puts. If I own stock Y and it is currently at $20. I might buy puts with a strike of $15. If I have 1000 shares I will take 10 contracts. I do this for fear that the stock goes to $10. If it goes to $10, I can have someone buy my shares at $15.

I am protecting myself by buying what amounts to insurance. That cost might be substantial depending on the price of the option, but that is the price of protection. If you end up needing the protection it can be great. However, if instead you get good news and the stock goes to $30 that money you spent protecting yourself is gone. Though you still own a stock that went from $20 to $30.

Consider the scenario where you bought the stock at $5. It is turnaround stock and things go really well. It shoots up to $20 in months. You expect a drop that might be moderate if there are a lot of potential buyers now that the stock is out of the danger zone, or it could be severe as people take profits after the stock was up 400%. You are sitting on large gains. You could close your whole position or some of it, and take your profits.

Suppose your investment thesis is still intact and your analysis says that $30 is doable, but there are a few risk factors that could lead to profit-taking at an epic level. You could spend some to protect your gains at $15, which is still $10 profit per share minus what you pay for the option. It is better than bearing the whole brunt of the risk. So puts can be used to protect your gains as well as mitigate your losses.

Calls work a little bit differently in that it protects your positive case, or is a hedge if you are short the stock. Same turnaround stock as above is at $5. You think that it could go to $20, but you don’t want to sink a bunch of money into owning a bunch of shares. You take a leveraged position by grabbing calls with a $10 strike and 2 years till expiry. After two consecutive earnings mega beats, the stock is sitting pretty at $20. You can sell your calls for a massive profit, or you can exercise your options and own the stock at a cost of $10 per share plus what you paid for the option.

Extra

What follows this sentence is an example of what happens when I just let myself continue talking. Note that this is a complex topic that warrants its own article. You can also continue to hold the option to expiry. However, if it does not continue upward you will see your overall gain shrink due to time decay. You have the $10 in intrinsic value locked in but the time value is extrinsic value that disappears as you get closer to expiry. The rate of decay will probably be less if you are that far in-the-money. If that weren’t bad enough, the information hinted at in this section is still very much part of the “beginner series” not the advanced theory.

Closing Thoughts

Options are difficult, and this basic article covers things that even beginner options traders understand well. The case is different for those that write options to generate some income, and I will have to discuss that separately. However, it is possible to write covered calls without getting too deep into the specifics of options. The “extra” section shows you that there is far more complexity right below the surface of all the threshold concepts I introduced.

I recommend reading this, taking a break, and reading it again. This article might seem like a ton of information, but there is a reason. I have basically expanded on every little piece of information. That way there is little room for ambiguity. It does mean that swallowing the information is a bit tougher. Rather than having to read 5 more articles on other websites to get a different perspective and the tidbits I left off, I included everything making this article move at a glacial pace but with everything you need to know before moving forward.