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posted on 24 August 2017

Basics On Options

by Russ Allen, Online Trading Academy Instructor

Our newsletter readership is always growing, so many readers are new in any given week. It is good sometimes to get down to the basics of option trading for those people who might be unfamiliar with the subject. That's what we'll do today by discussing the trading of stock options for profit.

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Many kinds of investors and traders will find trading options profitable and satisfying once they try them. I hope this article stimulates your interest in doing so.

Some people who have never tried options may have shied away because they believe they are complicated. And while the nuances can be complex, the basics are simple. They can easily be understood by comparing options to some everyday items with which we are all familiar.

Options Basics

First, there exist exactly two types of stock options. One type is referred to as the call option. The second type is the put option. We'll look at the call today.

The call is the option to buy stock. The everyday item that the call option resembles is a sale coupon. Here's an example. You see a coupon online or in a newspaper (remember those?) that offers a latte from your favorite coffee chain for $6.00. Latte prices are volatile, and $6.00 is a good price right now. The coupon is good through the end of the month. You save the coupon.

What is a call option?

You now have the ability, any time through the end of the month, to head to the coffee shop, turn over the coupon and the $6.00 and receive the latte. You can choose to do that; or you can choose not to. It is your option.

You pass the coffee shop on your way home. Lattes are posted at $6.00. No point in turning in the coupon.

You pass it again in a week. Lattes are now $7.00. Now the coupon is more valuable. You can turn it in today and save $1.00. You think, "What if lattes go up even more? I'll wait a while."

Over the weekend, the Brazil coffee crop fails. On Monday, latte prices are up to $15. And people are still buying lattes. In fact, they are standing in line to buy them, fearful that latte prices could go up even more before they get one. Now that coupon is really interesting. You could go into the shop, turn in the coupon and buy the now-$15 latte for $6. You could then go out to the people in line and sell one of them the latte for the going rate of $15, making a $9 profit.

While standing there congratulating yourself on this, another thought occurs to you. Why wait in line and buy the coffee at all? Why not just sell the coupon to one of the other people in line? They are more than willing to pay you $9 for it in order to save that amount and ensure that they have their price locked in. So, you sell it.

You just made an option trade. You had the right to buy the latte at a fixed price. The right was good for a fixed period of time. You could have exercised the option (bought the latte at the $6 price). You could have then kept the latte, or you could have sold it to someone else. But in the end, you made a profit by selling that right and never touching the latte at all.

Now add one small change: the coupon was not free, originally. You had to pay $1 for it, which you were willing to do because you thought there was a good chance that coffee prices would rise. In this example, it turned out to be well worth the price. A $1 investment turned into $9.

It could have gone differently. It might have been the case that the latte prices never changed before the end of the month. The coffee crop might have failed a day after the coupon expired. In that case, you would have been right in your belief that latte prices would rise, but the timing was off. You would be out a dollar and have to hope for better luck next time.

Here is the correspondence between the latte example and a call option on a $6 stock.

The latte, which in the stock option example corresponds to a share of stock, is called the underlying asset, or just the underlying for short.

The $6 price at which you had the right to buy the latte is called the strike price, or just the strike.

The date on which the offer ended is called the expiration date (some say expiry date).

The $1 price that you paid for the coupon/option is called the premium.

So in this example of a call option, you paid $1 (the premium) for the right to buy a latte or a share of stock (the underlying asset) at a fixed price of $6 (the strike price). The coupon/option was good through the end of the month (the expiration date).

See? Call Options are not that complicated.

Next we'll do the same with Put options.

Previously, we described one of the two types of stock options, the Call option, as being similar to a sale coupon.

Today we'll look at the second and last type of option, which is referred to as the Put option.

Very briefly, a put option is like an insurance policy. It insures the holder of a stock against a drop in the value of that stock.

Think of a truck that is worth $10,000. Obviously, we are talking about a used truck, although that's not important. $10,000 is just a nice round number.

The owner of the truck wants to be protected against its losing value in the event of a collision. He accomplishes this by buying an insurance policy. He is very risk-averse, so he buys a zero-deductible policy. If his truck is damaged in a collision, the insurance company will pay him enough to make him whole. If the truck is a total loss, the insurance company will pay him the full $10,000.

Put options are a lot like car insurance.

The insurance policy is good for a set period of time, say six months. The owner must pay the premium for that policy. Let's say that is $680.

For the period that the policy is in force, the insurance company will pay for any damage to the truck. IF it is totaled, the company will buy the worthless truck from the owner for the policy amount of $10,000. If there has been no damage to the truck, there will be no need to file any claims on the policy.

At the end of the six months, the policy expires. If after the policy's expiration the owner wants to continue to be protected, he will then have to buy another insurance policy, and so on.

The truck owner had other alternatives - other options. He could have decided not to insure the truck against collision damage. He could have saved the $680 in that way, but would have had no protection.

He could also have opted to save money on the insurance by buying a cheaper policy with less protection. A policy with a $500 deductible instead of a zero deductible would have been less expensive - the six-month premium might have been $485 instead of $680.

Now, let's look at a Put option on a stock to see the parallels with the truck's insurance policy.

We're going to call our stock PQR (just because XYZ is so overused). It is currently trading at $100 a share. A hundred shares of that stock would be worth $10,000. There are Put options offered for that stock that expire in about six months. To protect the full $100 per share value ($10,000 total), the price of a put is currently $680 - like the $10,000 truck insurance policy. The Put, once it's been paid for, gives the person who bought it the right to sell the PQR stock for the full $10,000 at any time they want during the six-month lifetime of the put. They just have to call their stockbroker and say, "Exercise my PQR puts." The PQR stock will be removed from their brokerage account, and $10,000 in cash will be deposited in it.

This means that if during that time the stock goes down to, say $9,000, the put owner can exercise the put and thereby sell the stock for the full $10,000.

In the event of a catastrophic crash, PQR stock might become completely worthless - its value might be zero. The stock will have been "totaled." Even in that event, the puts can be exercised and the full $10,000 recovered.

The party responsible for providing that $10,000 is the seller of the put. They have taken on the role of the insurance company. They have accepted the premium (the $680 put price). They are now obligated to buy the stock for the full $10,000 whenever they are ordered to by the put owner.

The put seller hopes that will never happen. And it won't if the PQR stock stays above $100 per share. There is no need to "file a claim" - exercise the put - if there has been no loss. If the put is not exercised by the time it expires, then the put seller keeps the $680 premium as clear profit.

The put seller's motivation for selling the put is like that of any insurance company. They intend to take in as much as possible in premiums, and pay out less in claims than the premiums collected. If they sell many policies, and have only a few claims, they will profit in the long run.

The stock owner could also have chosen to buy a cheaper put, if he were willing to accept a lesser amount of protection. A put that would pay $9500 instead of the full $10,000 could be bought for $485 instead of $680. This is like the truck owner buying a policy with a $500 deductible instead of a zero deductible, for $485 instead of $680.

So, here in summary is how the PQR put is like the truck insurance policy.

The put buyer (the truck insurance buyer) protects the value of an underlying asset with a $10,000 value - PQR stock, which corresponds to the $10,000 truck. The put buyer pays the premium of $680 for the put, like the insurance buyer pays the $680 premium for the policy.

The put buyer now has the right to exercise the option when he wishes, like the truck owner has the right to file a claim whenever his truck has been damaged. In both cases, the protection lasts for a fixed period of time - that is, until the expiration date.

The last wrinkle is this - anyone can buy puts on the PQR stock, whether they own any PQR stock or not. If a put buyer does not own any PQR stock, they are called a speculative put buyer. The put sellers are happy to sell puts to all comers, no questions asked.

That means that someone who believes the price of PQR will go down, can buy puts in order to profit from that drop in price. They can pay $680 for a 6-month option to sell the stock for $10,000. If the stock then does go down to $9,000, that person can go buy the stock for $9,000 in the open market. They can then exercise their put, turning over the stock they just bought for $9,000, and being paid $10,000 for it - a $1,000 gross profit.

After subtracting the cost of the put, the speculative put buyer would have a profit on the entire transaction of $1,000 - $680, or $320. If the cost of the stock had gone down by $2,000 instead of $1,000, then the put buyer would have made a thousand dollars more. Best case for the speculative put buyer is that PQR becomes worthless. They could then get the stock for nothing, and sell it for $10,000. The put seller is on the hook for that $10,000 regardless, and is required to have enough reserves to pay it.

So, the put option on a stock is very much like an insurance policy that anyone can buy. It can be used by someone who does own that stock to protect the value of it - to limit risk - exactly like truck insurance.

Or the put option can be used by someone who does not own that stock as a bearish speculation with limited risk. Worst case, the speculative put buyer loses the premium paid, which is a small fraction of the value of the asset. Best case, the speculation pays off in a big way.

Either way, the put sellers behave like insurance companies, collecting premiums and, hopefully for them, not paying out claims

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