I like to think I am a smart guy but I always make this joke that being blonde puts me at a learning disadvantage. I partly do it to make people laugh and I partly do it just in case I can’t learn as quickly as others. With that said, I am not going to fool you, call and put options explained to me the very first time made absolutely no sense to me. It was one of the few times in life I felt that maybe my biological circumstances were preventing me from understanding. However, with a little patience mixed in with examples of real life situations I was able to see how simple the concept of option trading really is. Don’t be fooled, options carry risk and you have to know when to use them but I have been successfully trading options for a few years now and I can honestly say that it is easy to understand. In fact, when you are done reading this post you will learn 3 things. 1. The concept of trading options is a cinch and 3. blondes are smarter than you think.
Before I get started, it’s important to know that this blog post is about learning the concept of trading options. It will not teach you how or when to trade them.
Let’s start out really simple.
What does the word Option mean?
In finance, options are contracts which gives the buyer the right, but not the obligation, and the seller the obligation, and not the right, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. I felt the same way when I read that definition. Ok, let’s break it down. What that means is, an option is an agreement between 2 parties for a valuable thing that could be be bought or sold in the future. In the contract the price of the valuable thing is agreed upon and the time frame the agreement is valid is agreed upon too. The person buying the agreement pays the seller a fee. If the price during that time frame isn’t reached within the agreement the 2 parties go about their way.
- The agreement is the option contract.
- The 2 parties are the buyer and the seller.
- The valuable thing in this example is a stock.
- The price agreed upon is the strike price.
- The time frame is the expiration date.
- The fee is the option premium.
Buyer of the contract (Option buyer) – The buyer of the option contract pays a fee which gives them the right to buy or sell the stock if the price is reached during the agreed time frame. If the price isn’t reached the buyer will not be forced to buy or sell the stock as the option contract becomes void. The buyer’s only loss is the fee paid for buying the option contract.
Seller of the contract (Option seller) – The seller of the option contract gets a fee from the sale of the option contract. If the price is reached the seller must buy or sell the stock. If the price isn’t reached under the time frame the seller doesn’t have to buy or sell the stock but gets to keep the option contract fee paid by the buyer.
Now let’s break down the two Options or contracts that we all get so confused about. There are 2 types of options. There are Call Options and Put Options. Let’s break down Call Options first.
What are Call Options?
A Call Option is a contract that gives an investor the right to buy a stock (ETF, bonds, commodities, etc…) at a specific price within a specific period of time.
Think of a call option like a security deposit or down payment.
To make it clearer let’s break it down with a simple and fun story.
Liz (seller) wants to sell her house (asset) valued at $500,000. Bob (buyer) is interested in buying it but doesn’t have all the money today so Liz gives him a contract (call option) to buy the house in 6 months (expiration date) for a $10,000 fee (call option premium).
Now that the agreement is made there are 3 possible outcomes to the story once the contract ends.
Scenario #1 – One night, Liz’s daughter accidentally set fire to the kitchen while cooking dinner. The house suffered severe damage which lowered the value of the house to $400,000. Bob decides he no longer wants the house as the value has decreased and so he walks away from the deal. Bob loses the $10,000 fee paid but Bob is happy to have only lost $10,000 and nothing more. Luckily for Liz, her talented next door neighbor Jai knows how to do repairs and even though she is upset that the value of her home has decreased she can put it up for sale again in the future.
Scenario #2 – During the length of the contract the world stayed the same which had no impact on the value of Liz’s house. So, the $500,000 house that Liz owns is still only worth $500,000. Bob now has 2 choices. He can walk away from the deal only out the $10,000 fee for the contract or he can believe the value of the home will increase down the road and buy the house at its current value of $500,000. So, with the contract fee paid, Bob’s cost for buying the house totals $510,000 even though it’s currently valued at $500,000.
Scenario #3 – Parks, shops, theaters and new complexes were added around town where Liz’s house is located. The entire city beautification increased the value of all the homes in the surrounding area. Liz’s house once valued at $500,000 is now valued at $550,000. Liz is now forced to sell her house at $500,000 even though the value went up $50,000. Bob can either keep it and live in it and be happy that he paid $10,000 for buying the contract and $500,000 for the house, or he can turn around and immediately sell the house and make a $40,000 profit.
Now let’s look at call options using Facebook as the stock example.
Let’s say Facebook (FB) is trading at $100 and you believe FB will go up to $120 in the future. You could potentially buy a $110 call option for 40 cents. If the stock goes up to $120 that would allow you to buy the stock at $110 which would give you a profit of $9.60 per share. However, the person who sold you the call would be (forced) obligated to sell FB stock at $110 at a loss of $9.60. If FB never goes to $120 by the expiration date, the call expires worthless and the call buyer loses 40 cents and the call seller gets to keep the 40 cents and doesn’t have to do anything with the FB stock.
*Note – call options can be closed out at any time during the length of the contract.
What are Put Options?
A Put Option is a contract that gives the option owner the right to sell a stock (ETF, bonds, commodities, etc…) at a specific price within a specific period of time.
Think of a put option like an insurance policy.
To make it clearer let’s break it down with a simple and fun story.
Jan (buyer) has a cool motorcycle (asset) valued at $20,000 but being that Jan is afraid that something might happen to the bike he buys a 1 year (expiration date) insurance policy (put option) from Ed (seller) for a fee of $2000 (put option premium).
Now that the insurance is set up there are 3 possible outcomes to the story once the policy ends.
Scenario #1 – One of the reasons Jan bought his cool motorcycle in the first place was so that he could speed around town. During one of his adventures he crashed damaging the bike pretty badly. The damage to the bike lowered the value down to $15,000. Ed now has to buy the motorcycle from Jan for $20,000. Luckily Ed got an insurance policy fee of $2000 so that he can off set the cost of the bike which in the end cost him $18,000. Jan is happy he paid the fee because he gets $20,000 for the bike even though it is now valued at $15,000.
Scenario #2 – Jan got busy making pizza at his pizza shop which left him little time to ride his cool motorcycle during the year. So, his $20,000 motorcycle maintained it’s value through the life of the policy. Ed walks away from the deal happy with his $2000 and no motorcycle and Jan walks away happy that he only paid $2000 to protect himself in case he got a little reckless on the road. Once things slow down in the pizza shop Jan has the ability to buy another insurance policy and protect himself again.
Scenario #3 – One of Jan’s competitors in the pizza business got mad that Jan’s pizzeria was doing better than his. So, he decided to steal Jan’s cool motorcycle. Jan had the last laugh because Jan’s competitor didn’t realize that Jan paid for an insurance policy and will still get $20,000 for his bike. Ed, is angry on the other hand because even though he got a $2000 fee Ed must pay Jan $20,000 without ever riding or seeing how cool Jan’s motorcycle really was.
Now let’s look at put options using Valeant Pharmaceuticals as the stock.
Let’s say Valeant Pharmaceuticals (VRX) is trading at $30 and you believe VRX might go down to $20 in the future. You could potentially buy a $25 put option for 25 cents. If the stock goes down to $20 that would allow you to sell the stock at $25 which would give you a profit of $4.75 per share. However, the person that sold you the put would be (forced) obligated to buy VRX stock at $25 even though it’s valued at $20 at a loss of$ 4.75. If VRX never goes to $20 by the expiration date, the put expires worthless and the put buyer loses 25 cents and the put seller gets to keep the 25 cents and doesn’t have to do anything with the VRX stock.
*Note – put options can be closed out at any time during the length of the contract.
There are many various ways to play call and put options and there are many different risk parameters involved but hopefully you understand the basic principles behind the puzzling idea of options. My biggest suggestion to anyone who is still confused is to try to understand 1 option play at a time. For example if you own a stock you might want to look into selling a covered call. If you can implement 1 profitable option strategy you can build upon that success with trying to understand and implement a 2nd strategy. Once you have nailed down all 4 option plays you can expand your knowledge even further with combining options together.