what are options

What are options and how do they work

You may have asked yourself what are options, how do they work? Maybe you read a bit about them but found it confusing. Don’t worry I felt that way too even though I already knew a fair bit about finance before I started.

Options have been around for hundreds of years, however, exchange traded stock options became popular at the end of the 20th century.

I’ll try to explain how they work in an easy way and then I’ll give you some examples with screenshots from the platform I use (Tastyworks).

What is an options contract

When you buy an option you receive the right but not the obligation to purchase or sell a given security at a pre-determined price called a strike price.

Conversely, the option contract seller has an obligation to you to deliver or buy the security.

Each stock options contract is for 100 options, however, the quoted price is for one. Therefore, if the option price is $1 this means that the value of one contract is $100. You can buy or sell as many contracts as you can afford or want to as long as there is sufficient liquidity.

What if the seller runs away with my money

Now you may think ok, what happens if the seller doesn’t deliver? There is a point because an options seller doesn’t need to own the underlying stock or they may not have enough money to buy it from you. However, you don’t have to worry about counterparty risk. The options market is well regulated so you’ll get your money.

Whenever someone sells an option the brokerage blocks a certain amount of collateral to cover any losses. This collateral, a.k.a. margin requirement, is dynamic meaning that it changes when the share price moves to ensure that the seller will deliver.

How does it work

You are probably familiar with account types like ISA and SIPP. For options trading you just need an account at a suitable brokerage firm. However, there is an approval process as options are more complicated than stock which can make it difficult to open one.

Before opening accounts let’s look at the most basic characteristics of an option: type, strike price, expiration date and exercise style.

Expiration date

All options have a set duration which can be anything between a few days and a couple of years. The market close on the expiration date is the end of the life of an options contract. It will be exercised if it is in the money or otherwise it will expire worthless.

About 70% of all stock options expire worthless. This begs the question why would anyone buy something like that? And the answer is that the return can be a lot higher than anything you can get out of a stock.

Below is a screenshot of the various expiration dates available for the SPY ETF options. The ones marked with ‘W’ are weeklies, ‘Q’ means quarterly and the rest are standard expiration.

options expiration

Strike price

Imagine that you are thinking of buying UBER stock. It is trading for $33.72 so you can either pay this price or wait for it to go down. The options situation is slightly different as the strikes available range from $15 – $55, mostly in $1 increments ($31, $32, $33, $34, $35, etc).

If you think that the share price will increase you can buy a call option at a strike higher than the current price. And if you believe that it will decrease you can buy a put option at a strike lower than the current price. In the event that you are right the price of the option will increase and you can sell it for profit. Otherwise it will expire worthless and you’ll lose your money.

Exercise style

There are three styles: American, European and Asian. This article will not cover Asian options.

American options

American options can be exercised whenever you feel like it prior to expiration. Therefore, if you bought a call option at a strike price of $10 and 3 days later the stock is trading for $20 you can exercise it and cash in $10 per share.

These contracts are rarely exercised prior to expiration as most traders prefer to sell them instead. An options contract’s value is formed by extrinsic and intrinsic value. Therefore, early exercise will only realise the intrinsic value leading to a loss of profit.

European options

European options can only be exercised on their expiration date. You are unable to cash in your profits via early exercise. Nevertheless, you can still sell the option in the same way as an American one. Many index options, such as SPX contracts, come with European style settlement.

Types of options contracts

There are two types, a call option and a put option. This section just explains how the two types work. Options can be used in a variety of ways and we’ll go more in depth in the coming sections.

Call options

Call options give you the opportunity to purchase a stock at the set strike price. Following from the UBER example above you can buy a call option at the $35 strike with a 62 day expiration. If the stock trades over $35 your option will be in the money, however, if the price stays at $33.72 or below $35 it will remain out of the money.

If UBER’s share price goes up to $36 the option will be in the money and will have an intrinsic value of $1 and some extrinsic value. This is in contrast with an out of the money option which only has extrinsic value. The out of the money option going to expire worthless if the stock keeps trading below the strike price.

The intrinsic value only exists when the option is in the money. If you have a call option with a strike price of $10 for example but the current share price is $11 you are in the money. Therefore, if you exercise it you will realise a profit of $1 per share which is the intrinsic value of the option. However, the option’s price may be $1.50 which means it has an extrinsic value of $0.50 and you may choose to sell it instead.

The extrinsic value reflects the cost of the opportunity to purchase the stock at a set price without any obligation to do so. An option to receive anything at a set price must be worth something as the seller will need to hold the asset for you. Why would anyone risk it for free?

An option’s price can be calculated by using the Black-Scholes options pricing model.

Put options

Put options give you the opportunity to sell a stock at the set strike price. If you have a given stock and you are worried that it may plummet you can buy a put option to protect it.

In the UBER example you can buy the $32 put option and if the stock price drops to $31 it will be in the money and it will have $1 of intrinsic value per share and some extrinsic value. Consequently, if the stock trades for $33 it will be out of the money, thus it will only have extrinsic value and it will be worthless at expiration.

The options chain

The options chain is the go to place for any trader. It contains all the information you need: prices, strikes, expiration date and more. Here is a screenshot to see what it looks like:

options chain

This sounds really complicated, why not just trade stock?

My main issue with stock is that it is very capital intensive and it feels a bit like a coin toss, you either make money or not. A lot of investors theorise that experience and skill deliver outperformance. However, this has not been substantiated by the results of active management or lack thereof.

If in doubt check out the performance of the Vision tech fund, they should have bought the Nasdaq instead. Moreover, investment banks and funds get wiped out far more often than you may expect considering they are in possession of the necessary expertise. You can find more examples here.

We’ll move on to some of the advantages and disadvantages of options but first let’s see what the pay-out of a stock looks like:

long stock pay-out

It’s pretty straight forward, if the stock goes up or down by $10 you either make or lose $10 per share. Short selling delivers the reverse, excluding any additional fees, as we can see it is just the opposite of the previous image:

Options give you opportunities

You can buy them but you can sell them too, both the calls and the puts. Are you short or long if you sell a put option? It’s both, you are short the option but you are long the stock. I’ll explain this in the next article when we talk about the Greeks.

I will use General Electric as an example. It is a cheap stock so it’s easy to calculate profit and loss. I don’t feel that the examples are necessarily good trades but should be alright for illustration.

What happens when you buy or sell a call option

The price of call options increases when the stock price goes up. You need to be aware that this is not strictly true because of volatility and time. However, we have to start somewhere so we’ll ignore time and assume that volatility is constant for the examples.

Buying calls

Why buy a call and not stock? The pay-out is completely different as you can see on the graph below:

You are looking at a 62 day $8 strike call option on General Electric stock trading for $7.29. The option costs $0.38 which means $38 for each contract of 100.

If you buy the options and GE doesn’t reach $8 you just lose $38. No matter if it’s trading for $2 or $7 the loss is the same. Surely if it trades for $7.99 you would have made money if you bought shares. However, there are $7 strike options too so planning is important.

Looking at the screenshot you can see that if GE reaches $12, which is improbable, you’d make $400. Buying 100 shares of stock would result in a gain of $471, however, you would have spent $729 instead of $38.

Realistic example

I’d be surprised if GE reaches $12 within 62 days but if it goes a bit over $8 you’d double your money. Now we’ll have a look at the past, below is a chart of the SPY ETF which shows that it traded for about $336 on the 20th of Aug 2020 and $351 on the 01st of Sep 2020.

spy stock

What if you bought SPY for $336 and then sold it for $351, that’s not unreasonable. You’d make $1,500 on your investment of $33,600, that’s not bad, 4.45% in 10 days. Had it gone down to $321 you would have lost the same amount.

I have to compare this to a call option. If you spent $33K on SPY you clearly had a strong conviction that it was going up. Therefore, it wouldn’t be a bad idea to check what would have happened if you bought the 20 Nov 2020 $346 call option instead of the stock. Here is the chart:

spy call option

You wouldn’t have bought and sold the options at the perfect moment so we can say that $9.50 is a reasonable purchase price and $18 is an acceptable sale price. The result is a gain of $8.50 per option or $850 per contract. It is less than the stock in dollar terms but you still made 89.47% profit. We also have to consider that you spent $950 instead of $33K. In case that SPY crashed or something the $950 is all you could have lost.

Even more realistically, SPY is currently trading for $347 which means the profit from the shares is $1,100 or 3.27%. The option is currently $10.30 so you’re still looking at 8.42% profit. However, I wouldn’t buy options for a 10% return, therefore, I’d say it broke even if you somehow didn’t sell it for 100% profit.

What about volatile stocks

Sometimes I look at a stock and I want to trade it but at the same time I don’t because I have a really bad feeling about it. That’s when options come into play.

There were news about HTZ’s new $1.9 billion financing last week which sent the stock 90% up. I’m not going to trade it as I don’t see any more upside to it but others do. Regardless of any prior beliefs we are all concerned about losing money.

You can’t lose that much on a $2 stock but still 400 shares will cost around $1K. I’m not happy to lose that on a bankrupt company so I’d check what are the prices of the options:

options prices

The 461 day options don’t seem that expensive compared to the 181 day ones. I’m not sure what the profit expectation on HTZ stock may be like but I can’t see it trading for more that $6 – $8.

Actually, I’m more inclined to think that it will just go bankrupt. However, since we’re looking at this for the sake of the argument I’ll settle on a maximum price of $6 or $3.5 profit per share. The cost of 100 shares is around $250 which is also the maximum loss and we’re expecting $350 profit if successful.

In terms of the options, I’d be looking to pay around $88 for the 461 day $3 strike call. If HTZ makes it to $6 I’d expect to collect $300 in intrinsic value and enough extrinsic to cover my original investment.

For me these trades are exactly the same except for the maximum potential loss which is reduced by 65% if I was to go for the options.

Selling calls

This is similar to shorting stock except for the capped upside of the trade. You just get the options premium no matter how low the stock goes. The bad part is that the loss from the trade is theoretically unlimited.

Your brokerage platform will show an infinity sign next to max loss. This is not realistic as the price cannot reach infinity. I suppose I could argue about a limit of infinity but this would also be far fetched. In more realistic terms the loss can be fairly substantial. Let’s examine GE again:

We are looking at the same $8 strike call as before only that now we are selling it.

This time I’d be paid $38 to take on the obligation of selling 100 GE shares for $8 each. Therefore, if GE keeps trading below $8 I’ll have a $38 profit at expiration. However, if GE trades for $9 I’ll lose $100 ($1 per share) minus the $38 I already collected from the option so a total of $62. This goes up to $562 if GE reaches $14.

The loss can occur in two ways. Either the price of the option will go up and I will have to buy it back at a loss or I will get assigned 100 shares. Since I don’t have any GE stock I will be short 100 shares and I will need to buy them back at the market price. If the price is higher than the strike I will realise the difference as a loss minus the initial $38 I collected.

Final thoughts on selling call options

I’m sure that you already think that this is a really bad idea and you are absolutely right! Selling a call only makes sense as part of a strategy or if there is decent money to be made. This is not the case when you sell put options which we’ll discuss in a bit.

The purpose of the example is to emphasise how substantial losses can be. You probably noticed that the pay-out for selling the call is exactly the opposite to the one you get when you buy it.

In conclusion, buying a call gives you high profit potential against the risk of a limited loss. Selling a call results in a limited profit which comes with the risk of a substantial loss.

What happens when you buy or sell a put

We are moving to the downside and we’ll start with buying puts. The price of a put option increases when the stock price goes down. Again, we are ignoring time and volatility for the time being.

Buying puts

Buying a put is somewhat similar to selling a call but a bit different at the same time. The similarity is that you benefit from this if the stock goes down but this time you have a limited risk while your return is variable. I didn’t say unlimited as the stock can’t go below zero. Here is a graph to visualise it:

This time we are buying the $7 strike put as the $8 is in the money and we have to pay for the intrinsic value. We’ll spend $51 dollars and the maximum profit is $649 if GE goes bankrupt.

That’s not happening within the time frame we have. Therefore, it’s more realistic to aim for about $50-100 worth of profit if it goes down to $5. The advantage compared to selling a call is that there is no way to lose more than the initial $51.

If we compare buying a put to short selling stock we’d find a few advantages. There are no hard to borrow fees to start off with. Then our maximum loss is capped from the start so we have very clear expectations. And lastly we benefit from the leverage of the options contract. It would be fairy normal to aim for a multiplier of the initial cost rather than a percentage gain.

The disadvantage is that we have to pay money upfront.

Selling puts

When you sell a put you agree to purchase stock at the strike price of the option. Similarly to selling a call option you collect the premium upfront this time for the obligation to buy the shares. Here is the last example with GE:

I will need to pay $730 for 100 shares of GE if I wanted to buy it at all. What if I think that this is a bit expensive for me and I’d rather pay less? If I didn’t trade options I’ll have to wait until the price goes down and it may or may not do so.

Instead of just waiting I can sell the $7 strike put for $51. If GE trades over $7 at expiration I’ll just have $51 more in my account and then I can sell another put if I still want to buy the stock. However, the share price may drop which is when losses can occur.

Losses from selling puts

I already have $51 from the trade so if GE trades for $6.49 at expiration I’ll break even. Anything above that will be a small profit or break even and anything below will be a loss. For example, if the share price goes down to $5 at expiration I’d lose $149 ($200 minus the $50 collected for the option) but I’ll have 100 shares. Had I bought the shares outright I’d be down $228 so I’d have lost 34% less by selling the option.

The worst case scenario is if GE goes bankrupt which yields the maximum loss of $649. This is lower than the $729 potential loss from the shares.

Final thoughts on selling puts

Selling the put gives me the opportunity to buy the stock at a discount. It just makes sense. If I’m buying a product I shop around to get the best price or check for any coupons so why should it be different when it comes to stock. I know it sounds a bit stingy but I don’t feel that there’s anything bad about making an extra buck or a few. We don’t trade for leisure, just to make money.

GE is a cheap stock so the options are cheap too. This is not the case when it comes to more expensive stocks as they can bring a few hundred dollars per contract. Check out the prices in the Twitter chain, a $45 stock:

option chain

Conclusion

Congratulations, now you know how options work. Don’t worry if you found it a bit confusing, it takes some time for the information to sink in.

One of the difficulties we face when first learning about options is that we all came from stock. Shares are easy to understand, you buy or short them and they go up or down.

You will probably agree that options are different, you can either sell a call or buy a put if you want to be short and the reverse if you want to be long. And we haven’t even talked about the Greeks or the various strategies available.

I have to admit that options are not everyone’s cup of tea but it is always worth to look into different ways of trading and just use the one which is best for you. It doesn’t hurt to know what your options are!