ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel
  • »
  • Personal Finance»
  • Investing in Stocks, Bonds, Real Estate, More

Options Demystified

Updated on December 1, 2011

Many people cringe when they hear about options, and while options may seem too complicated for anyone to understand, they really aren’t. Whether you want to trade them or simply better understand the stock market, options are a truly fascinating concept.

Basic Definitions

Options give people the right to either buy or sell a stock, for a given price, before a certain date. In order for an option to exist, someone has to “write,” or sell the option, and someone else has to buy the option. Essentially, options are a zero sum game between two individuals: Somebody wins and the other person loses.

Call – the right to buy

Put – the right to sell

Underlying stock – the stock which the option gives the right to buy or sell

Strike price – the price at which the option can be exercised

Expiration date – the date at which the option expires

Option price – the price at which the option is currently trading

Contracts – 100 options bundles (options are sold in contracts)



Call Options

When someone writes a call option, they are betting that the stock will not surpass the strike price. On the other side of the deal, when someone buys a call option, they are betting that the stock will surpass the strike price. Let’s go over an example. First, take a look at the table below:

Now, let’s say that on November 22, 2011 someone writes 5 contracts of Ford call options, with a strike price of $11.00 and an expiration date of March 17, 2012. Next, let’s say that today is March 17, 2012, and the market price of Ford is $13.00.

From the Buyer’s Perspective:

On November 22, 2011, the buyer would have paid $0.64 * 500 = $320 for the 5 contracts of Ford call options (see the blue circle on the table above for the option’s price). Then, on March 17, 2012, the buyer would exercise his options and purchase 500 shares of Ford for a total of $11.00 * 500 = $5,500. Therefore, the buyer would have spent a total of $320 + $5,500 = $5,820. Immediately after exercising the call options, the buyer would go into the open market and sell his shares of Ford for the market price of $13.00, generating a revenue of $13.00 * 500 = $6,500. In the end, the buyer makes a PROFIT of $6,500 - $5,820 = $680 (minus brokerage fees and taxes, of course).

From the Writer’s Perspective:

On November 22, 2011, the writer would have received $0.64 * 500 = $320 for the 5 contracts of Ford call options he sold (see the blue circle on the table above for the option’s price). Then, on March 17, 2012, the writer would have to go into the open market and buy 500 shares of Ford for the market price of $13.00, which would cost a total of $13.00 * 500 = $6,500. The options would then be exercised, and the writer would have to sell his shares of Ford for the strike price, generating a total revenue of $11.00 * 500 = $5,500. Adding this revenue to the revenue generated from selling the options, the writer would have a total of $5,500 + $320 = $5,820. In the end, the writer LOSES a total of $5,820 - $6,500 = $680 (plus brokerage fees).



Put Options

Put options are essentially the opposite of call options. When someone writes a put option, they are betting that the stock will not fall below the strike price. On the other side of the deal, when someone buys a call option, they are betting that the stock will drop below the strike price. Let’s go over another example. First, take a look at the table below:

Now, let’s say that on November 22, 2011 someone writes 5 contracts of Ford put options, with a strike price of $9.00 and an expiration date of March 17, 2012. Next, let’s say that today is March 17, 2012, and the market price of Ford is $7.00.

From the Buyer’s Perspective:

On November 22, 2011, the buyer would have paid $0.60 * 500 = $300 for the 5 contracts of Ford put options (see the blue circle on the table above for the option’s price). On March 17, 2012, the buyer would go into the open market and buy 500 shares of Ford for the market price of $7.00, which would cost a total of $7.00 * 500 = $3,500. Therefore, the buyer would have spent a total of $300 + $3,500 = $3,800. Immediately after buying the shares, the buyer would exercise his put options and sell his shares of Ford for the strike price, generating a total revenue of $9.00 * 500 = $4,500. In the end, the buyer makes a PROFIT of $4,500 - $3,800 = $700 (minus brokerage fees and taxes, of course).

From the Writer’s Perspective:

On November 22, 2011, the writer would have received $0.60 * 500 = $300 for the 5 contracts of Ford put options he sold (see the blue circle on the table above for the option’s price). Then, on March 17, 2012, the options would be exercised, and writer would have to buy 500 shares of Ford for the strike price, costing a total of $9.00 * 500 = $4,500. If the writer needed the money, he would go into the open market and sell his Ford shares for the market price of $7.00, generating a total revenue of $7.00 * 500 = $3,500. Adding this revenue to the revenue generated from selling the options, the writer would have a total of $3,500 + $300 = $3,800. In the end, the writer LOSES a total of $3,800 - $4,500 = $700(plus brokerage fees).



Conclusion

This article is just a brief overview of options trading. For more in-depth information about options, please check out my future articles. Remember: If you buy a call option, you want the price of the underlying stock to increase as much as possible. If you buy a put option, you want the price of the underlying stock to decrease as much as possible.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.