The Beginner’s Path to Options Knowledge — a 1-2-3 plan

Are options brand new for you? Then you’ve come to the right place – we’ve put together a multi-media guide to help you navigate the sometimes confusing, often intimidating world of options.

We want to show you that you already know more about options than you think, and that at their most basic level, options can be simple to understand and almost intuitive to use. In reality, options are based on a lot of everyday transactions and common sense. Check out our learning plan for you: The Beginner’s Path to Options Knowledge.

1. Read the Introduction below
2. Watch our Options Physics Basic videos series and read the accompanying text with each video.
3. Use the Beginner’s Glossary, “The Language of Options”
4. Register and attend the weekly ONN webinar series to interact directly with the ONN crew.
5. Test your stock trading ideas in the ONN OptionFinder to find options ideas that offer a better ROI.
6. Set up a risk free virtual trading account with OptionsHouse to practice the results generated by the ONN OptionFinder, ideas from our Trading Ideas articles, or your own picks.

Introduction

It’s been 36 years since options trading debuted on the Chicago Board Options Exchange, and the investing landscape has never been the same. Back on April 26, 1973, the first-ever day of exchange-based options trading, 911 contracts traded on 16 stocks. Fast-forward to today, and roughly 3.5 million option contracts trade every day on more than 3,000 equities and exchange-traded funds (ETFs). Option trading is here to stay, and investors wanting to keep pace with the changing tide need to educate themselves about basic options concepts, if nothing else.

Dependencies and Derivatives

You may hear people refer to options as “derivatives,” because option prices are derived from something else – the price of the underlying stock, index, or ETF. An option contract, when purchased, is not attached to something tangible. Instead, it’s merely the right to buy or sell 100 shares of the underlying stock or index, at a specific price level, on or before a specific date. A sold option contract, also not tangible, is the obligation to sell or buy 100 shares of the underlying instrument at a certain price on or before a certain date.

What’s a Call? What’s a Put?

A call option contract gives its owner the right (but not the obligation) to buy 100 shares of the underlying security (stock, ETF, HOLDR, or other investment instrument) at a specified price (the “strike price”) on or before the option contract’s expiration date. A call buyer pays a premium for the innate right of the contract.

The call seller pockets this premium (minus those pesky brokerage commissions and fees) at the trade’s execution, and has the obligation to deliver the underlying shares (100 per option contract) for the strike price if and when a buyer decides to exercise the call position (implementing the right to buy the underlying shares). A call buyer does not have to exercise his calls; he can also opt to close the call early (booking a profit or a loss on the option) or can let the contract expire.

A purchased call, also known as a long call, is typically a bullish strategy. A long call will generally rise as the underlying security increases in value, so these are used by investors expecting upside in the stock or ETF. As such, the long call theoretically has unlimited profit potential up until expiration. The maximum loss for the call buyer is the premium paid for the option contract (plus commissions and fees).

The put is simply the mirror to the call, employed by bearish investors. A call buyer typically seeks to benefit from a rally in the underlying. If, however, the investor expects downside in the chosen security, she might opt to purchase a put. All things being equal, a put will usually increase in value as the underlying security declines.

A put option gives its buyer the right (not the obligation) to sell 100 shares of the security at the specified strike price. As with a call contract, this right is valid until the put buyer exercises her option contract or the option expires.

In exchange for this right, the put buyer pays a premium to the put seller at the trade’s outset. For every contract sold, the put seller may have the obligation to purchase 100 shares of the underlying at the strike price on or before the chosen expiration Friday, which is the third Friday of the month. Note that the put seller is obligated only if assigned; there is always the possibility that assignment does not happen.

The put buyer theoretically benefits from any downside in the underlying until it is worthless (trading at zero); the maximum loss is the premium paid (plus any commissions and transaction fees).

Traders who sell calls or puts have limited reward and unlimited (or substantial) risk. Generally speaking, the appeal of most option-selling strategies is a higher winning percentage.

Calls and puts are the first two fundamentals you need to learn options trading. From these, you can build a foundation that includes more complex option strategies, from iron condors to butterflies, straddles to strangles. But no matter how complex strategies may become, calls and puts are the tools to create all of them.

Risk and Reward

When you buy a stock, you are poised to gain or lose a dollar (and a percentage) value as that stock moves higher or lower. Pretty simple, right? Determining risk and reward is a little different for calls and puts, but it is just as simple – in fact, it is fairly absolute.

Long Call:

RISK – Limited to 100% of the premium paid (plus commissions)

REWARD – Theoretically unlimited

Short Call:

RISK – Theoretically unlimited

REWARD – Limited to the premium collected (minus commissions)

Long Put:

RISK – Limited to 100% of the premium paid (plus commissions)

REWARD – Theoretically unlimited until the underlying security reaches 0

Short Put:

RISK – Theoretically unlimited until the underlying security reaches 0

REWARD – Limited to the premium collected (minus commissions)

Decisions, Decisions

Once an options investor has selected an underlying stock or ETF, she has to decide four things:

1. Bullish or bearish: Does she expect the stock to go up or down? This determines whether she will be buying (or selling) a put or a call. (Note: brokerage firms typically have restrictions concerning option selling, as the dollar risks can be greater.)
2. Target price: How far does she think the stock will move (higher or lower)? Once she determines this, she can choose her option’s strike price, or the price per share for which the underlying may be purchased (for a call) or sold (for a put) by the option buyer.
3. Time frame: When does she expect the stock to reach her target? This decision will help her select the expiration date, or the last day on which an option may be closed out. For stock options, this is almost always the third Friday of the expiration month. An option contract’s expiration can be anywhere from one day to two-and-a-half years in the future.
4. Risk/Reward: She needs to decide how much she is willing to lose. Stop-loss levels can then be determined.

To sum up, once the investor decides she’s going to trade XYZ options, she needs to decide how short- or long-term she wants to go, and how aggressive she wants to be.

Option Pricing

An option contract’s price is derived by six variables, as outlined by the Black-Scholes Model. (Don’t worry – we’ll get to that later in the Options Physics videos.) Obviously, the stock price is one of the most dynamic variables and has direct impact on the option’s price. Other variables include time until expiration, current interest rates, dividends, and implied volatility (another concept you’ll learn about down the road). The one variable that can never change during the life of an option is strike price, or the price at which the underlying stock can be sold or purchased.

Some Differences Between Options and Stocks

1. Options expire. Stocks typically do not (unless the company declares bankruptcy, goes private, or otherwise stops doing business).
2. Options investors do not collect dividends. Unlike shares of stock, option contracts do not actually give the investor a piece of ownership in the company.
3. Options buyers do not require a commitment. The buyer has, as the name implies, the option to buy or sell the underlying instrument. But an option buyer can decide not to exercise his option at any time. Sellers, however, do have to fulfill their commitment if assigned.
4. An options buyer’s risk is limited to the amount paid for the contract (plus commissions). The dollar risk for a stock buyer can be substantially higher. (For example: an XYZ 60 call, representing potential ownership in 100 shares of XYZ, may cost $3.50, or $350 per contract, while 100 shares of XYZ may cost $6,000).
5. While stocks and ETFs can trade in penny increments, option strike prices are usually in round-number intervals, such as $2.50 and $5.00.

For those who learn better through analogies, let’s take a real-world look at the concept behind calls and puts.

How Is a Put Option Like Car Insurance?

If you own a car, you probably have to pay semi-annual or monthly insurance premiums. What are these insurance premiums actually for? To limit your risk in case of one of life’s common experiences: a car accident. You pay a set amount for the year based on your insurance company’s assessment of the risks you pose as a driver. But you get to select the types of coverage you want and the deductible you prefer.

A put option (or simply a “put”) essentially behaves like car insurance. This type of option can protect owners of stock from a fall in the price of those shares. Put buyers pay a premium for the put option, and select the level (the “strike price”) and duration of coverage. For example, let’s say you own 100 shares of Amazon.com (AMZN) stock at $60 and have unrealized gains of $10 with the stock trading at $70, but you think the stock could move lower in the short term. You don’t want to get rid of your shares, but you want to be protected from the little bit of downside you are anticipating.

So you could buy a $65 October put option contract for $2 per share and be protected from losses below $65 until the option expires in October. In this example, your premium for this “stock insurance” is $2 per share and it is as if you have a $5 per-share deductible. Even though the stock is currently trading at $70, you have chosen to seek protection below the $65 level (a drop of $5 in the stock). If you had bought a $70 put option, you would have more protection, but guess what? That protection would cost you more, say $8 per share. And you could extend your coverage out to January by using option contracts that expire in that month, but that additional protection would also cost you more premium.

What’s the so-called downside? You never need the insurance, and you’ve “wasted” the monthly premium. But for most people, that money is worth the peace of mind (not to mention that driving without insurance is illegal!).

How Is a Call Like Renting-with-an-Option-to-Buy?

Now, let’s look at a common example of the other type of option, the call option. Pretend that there’s a house you’d really like to buy at or near its asking price, but you just don’t have the financing together to get a mortgage this year (an increasingly familiar situation these days!). You could make a deal with the seller and sign a contract, locking in the price of the house and giving you 12 months to arrange your financing and get a mortgage before closing. If you are not able to buy the house within that year’s time, the contract expires and so does your right to buy the house at that agreed-on price. Some people buy their first homes through such deals, often called “renting with an option to buy.”

This is very much how a call option works. Some investors would like to buy stocks at today’s prices, but they just don’t have the money for 100 shares. And if they are relatively certain about some future fund inflows, they may decide to lock in their buying price today using call options.

For example, let’s say you would really like to invest in a casino stock like Las Vegas Sands (LVS) because of all the growth they are experiencing in Asia. You also think it’s a great time to make this investment because of how low the shares have dropped recently, and you think the stock will bounce back fairly soon from the bargain levels of around $10. One problem: You don’t currently have the $3,000 you would need to purchase 300 shares. But here’s the good news: you’re expecting a year-end bonus at work that will allow you to make this purchase. So how can you lock in a buying price today that will guarantee your purchase price until your bonus comes through? For just $1,200 ($4 per contract), you could buy three December 10 call option contracts on LVS stock. These contracts will enable you to buy 300 shares at $10 at any point through December expiration, even if LVS rallies to $20, $30, $40, or higher!

Buying these December call option contracts gives you the right, but not the obligation, to buy LVS stock at a specified price ($10 in this case), just like the rent-with-an-option deal on the condo locked its price for a pre-determined amount of time. And remember these call option contracts might only cost you $4 per share, or $1,200 total for the protection against rising share prices before December (that’s $4 per share x 100 shares for each contract x 3 contracts = $1,200). And what happens if Asia decides it doesn’t like gambling after all? That’s easy – you’ll only lose your premium (and commissions).

In both of these examples of buying options to insure against loss (or to lock in a purchase price), your total risk is limited to the premium you paid. These option sellers take on the unlimited risk that insurance companies often do. This will be a theme we discuss many times along your “Beginner’s Path to Options Knowledge.”

All clear? If not, don’t worry. You’ll soon begin the audio-visual portion of your path to options knowledge. Click on over to the Option Physics Basic video and continue your educational journey.