Introduction to Options: Puts and Calls

Introduction to Options: Puts and Calls

It's easy enough to find plenty of information with a quick internet search about put and call options. Often the explanations are very complex. With the following articles I will be breaking it down into simple terms in bite sized increments. The accompanying video will provide context as to how these apply to an actual trading platform. In this case we will be using Thinkorswim with the paper trading feature.

Options are derivatives of stock or futures referred to in this case as the underlying. They are contracts to buy or sell a stock at a given price by a certain time. That price is called the "strike" and that time is called "expiration". They (for the most part) come in lots of 100. So a 1 lot of calls is 100 contracts to buy the stock and a 5 lot is 500 contracts.

Battle Station

Call and Puts

There are two types of options:

  1. calls Calls are contracts to buy a stock.
  2. puts Puts are contracts to sell a stock.

For example, a call at the 10 strike that has an expiration for DEC14 is a contract that allows the owner to buy 100 shares of the stock or underlying for 10$ anytime up to and including the day of expiration. DEC14 refers to the monthly expiration date which would be the 3rd Saturday of December 2014. So then a put at the 10 strike for the same expiration would allow the owner to sell 100 shares of the underlying at 10$ per share by DEC14 expiration.

What Can You Do With Options

There are three things you can do with any options. You can buy,sell or exercise.

  1. Exercising an option is to exercise your rights of a contract you have bought. Which simply means that if you bought a call you can exercise the option to buy the underlying at the strike price and if you bought a put you can exercise the option to sell the underlying at the strike price.
  2. Buying an option gives you the right to exercise the contracts.
  3. Selling an option gives you the obligation to fulfill the contract if it is exercised upon you.

What is Intrinsic and Extrinsic Value

There are 2 things can that give value to options:


  1. Intrinsic Value- this refers to how much more the underlying is worth beyond the strike price. For example If a stock is trading at $10.55 then a call at the 10$ strike has .55 worth of intrinsic value. (When an option has intrinsic value it is said to be "in the money".)
  2. Extrinsic Value- this refers to the value given for the amount of time and volatility left in the option. For example if a stock is trading at $10.55 and the call at the 10$ strike is trading at 1$ then the call would have .55 of intrinsic value and .45 of extrinsic value (.55+.45=1$).

USO

Options chain for USO on the Thinkorswim platform.
Options chain for USO on the Thinkorswim platform.

Summary

So to summarize, when an option is In The Money it has both intrinsic and extrinsic value. When it is Out Of The Money it has only extrinsic value. Options can always have some amount of extrinsic value right up to expiration. But they may have very little to none if they are very far out of the money and/or near expiration. An option will only have intrinsic value if it is in the money.

This has just been a quick introduction to help to understand what options are and what gives them value. We will look further into how these basics can be applied to our trading as we go.

Options Vocabulary

Vocabulary Terms:

  • put
  • call
  • options
  • derivatives
  • underlying
  • strike
  • expiration
  • right or obligation
  • intrinsic value
  • extrinsic value
  • in the money
  • out of the money

Video Summary Using Thinkorswim

PS

I think it is important to create a basic foundation before learning actual strategies. So the first series of videos will provide that foundation to build on so that when we get to the actual investment strategies one will be able to grasp the concepts. When you have a firm understanding of the concepts it becomes much easier to solve the problems as they come.

Feel free to offer any suggestions for future tutorials or suggestions in the comments. Thanks

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