After dipping your toes in the stock market, you probably have started to notice some people making it big with options trading. Maybe you are starting to hear the terms “calls and puts” and are wondering how people are making so much money off of them. If you found yourself here though, you are hopefully interested in learning the fundamentals of what is going on behind the scenes of these option trades. Before you can truly understand what a call or put is, you need to first understand the principals surrounding an option. In this article, I am going to help you visualize these principals, by comparing trading options, to a more familiar concept- buying/selling a house.
Defining a Few Basics
While browsing the real estate market, say you found a house you were considering to buy for 500k, and the seller allowed you to put a deposit of 5k on the house to hold it for 30 days. By putting down a deposit, you are essentially binding yourself in a contract. With this contract you are obligated to buy this house in 30 days at 500k. If you decide not to buy the house, you would lose your deposit of 5k. The contract described above illustrates the foundation of an option, and now it will (hopefully) be easier to understand how these contracts look in the financial market. With this concept in mind, I am going to further define three principal characteristics of options:
1. Strike Price- "500k"
The strike price in our example above is 500k- the agreed upon price for which the house would be bought/sold. Similarly, with options, we can look at the strike price as the agreed upon price for which a stock can be bought/sold. While maybe a hard concept to grasp, it is important to understand that the strike price is not the same as the current stock price.
2. Option Price- "Deposit of 5k"
Now that you have an understanding of the strike price, the option price can be defined as how much you pay for the contract. In our house example, the option price would be the deposit of 5k. There are many factors that go into an option price as a financial instrument, but to review the basics, option prices can be reflected by “bid/ask.”
Bid= price you receive when selling
Ask= price you pay when buying
ALSO- option prices reflect 100 shares of the underlying stock, meaning that these numbers are multiplied by 100 to give you the real price. SO, when you go into your trading table and see a bid for “8.45” this will actually cost you $845.
Soo What is An Option?
An option is a contract, where a buyer and seller agree on a strike price to trade a stock. The buyer pays for the option which will give them the right to buy/sell the stock until the selected expiration date. Honoring the strike price, the seller, not only has the right, but the obligation to sell the shares of stock.
Still Confused?
An option basically gives you the right to buy/sell a stock at a certain strike price, but why would you even want this contract? The answer is many many reasons, but to go easy on your brain I will make this short and sweet. If the stock price is currently at $50, but you have an option contract to buy the stock at $30. You just made $20. This goes with any market. If you are at the store and milk is $3 but you have a coupon to buy the milk for $2, you just saved a whole dollar. Your coupon in this case, is your option. It is that simple.
ALSO- You do not actually buy/sell the stocks
Let me explain by using our coupon analogy-
First, imagine a world where citizens traded coupons. NOW- What if you bought a coupon for $.50 that allowed you to buy milk for $2 and then the store lowers the price to $1? Well, your coupon would be worthless, and you would be out $.50- the price of your coupon. What if the store raised the price of milk to $5? Are you going to go to the store, buy the milk for a discount and then resell it? Absolutely not. You are just going to sell your coupon to a buyer who needs milk. If you paid $.50 for your coupon, and sold your coupon for $2- a price still worthwhile for the buyer, you have just made yourself a profit of $1.50. Options contracts should be looked at the same way. You are not going to go buy your stock for a discount and then resell it, you are simply just going to sell your contract to an interested buyer.
Main Ideas
1. Strike price– The agreed upon price of the stock to enter the contract
2. Option price– How much your trade is going to cost you, or how much money you will receive from a trade
3. Expiration date– Tells you the amount of time you have until you have to buy/sell the stock
4. An option gives the buyer the right to buy/sell stocks, but not the obligation to trade them. The seller of an option contract has the right, but also the obligation to trade the shares of stock.
5. You do not go into the market, and buy/sell your stocks to enter a contract, you simply trade the options contract