Options Overview
Options are contracts that represent 100 shares of stocks. The option contracts can be bought, sold, or exercised (said otherwise, to use the contracts to one’s advantage). The option contract is basically an agreement to which you have the right to buy 100 shares (call option) or sell 100 shares (put option) at a precise stock price, which we will call strike price, the moment you wish to exercise the option contract. In most cases, option contracts will be traded and not exercised unless that is the intention of the trader. Option contracts have deadlines for which a contract can be traded for that act like its expiration date.
First, let us go over the key concepts and metrics of an option contract to better understand options.
· There are two types of options, a call option, and a put option. A call option is a bullish contract in which you believe that the stock price will rise. If the stock price rises, you will make a profit. If the stock price falls, you will be losing money. A put option is the opposite, meaning it is a bearish contract in which you believe that the stock price will fall. For a put option, you make money if the stock price falls, and you lose money if the stock price rises.
· Each option has a strike price. A strike price is an amount that you agree to buy or sell 100 shares if you exercise the option. There are multiple strike prices that you can choose to buy/sell an option for. For example, I want to buy a call option contract that allows me the right to buy 100 shares of Tesla stock at a strike price of $600. Therefore, $600 will be the strike price that I will need to buy 100 shares, which will total $600,000 if I decide to exercise the option.
· Each contract represents an agreement upon buying or selling 100 shares. Therefore, we will use a contract multiplier to calculate the premium of a contract. A premium is the total cost of a contract which equals the fees for one contract multiplied by 100. For example, I want to buy a call option contract that costs $11.90 granting me the right to buy 100 shares of Tesla stock at a strike price of $600. The premium cost for one contract will be $11.90 multiplied by 100 which equals a total premium of $1190. This will be the cost of buying that contract that we call premium.
· Each option has an expiration date. Just like there are multiple strike prices that you can choose to purchase or sell an option for, there are different expiration dates. Most expiration dates are on Fridays. You can purchase options that expire at the end of the week, in two weeks, one month, 6 months, a year or more. The same selection of strike price will be available for each expiration date. Depending on the expiration date, the premium will change. This is due to the simple reason that an option with a longer expiration date has a greater chance of having stock price fluctuation than an option with a shorter expiration date.
What are the risks involved in options?
Options are more volatile than owning stocks. For example, a 4% increase in stock price can fluctuate the option contract in a rise of 20%. This is great when the fluctuation is to the favor of your contract. If it is not, then your loss is greater in percentage than someone that owns the stock. At the same time, you have to realize, the losses only apply on the premium of the contract. Hence, the maximum loss is losing the entire premium.
Another important factor to be aware of is that unless you are using some more advanced options strategies, the stock needs to move on the upscale if you have a call option or to the downside if you own a put option to be profitable. If the stock keeps trading sideways (in other words the stock stays more or less stable), then you will lose money as time passes and approaches the expiration date of the contract. This is due to time decay.
Thus, the main risks of trading options are first, the stock needs to move in your favor; if it trades sideways, you will lose money due to time decay. Second, options are much more volatile; you can quickly lose most of your premium and sometimes even all of it.
This is an example of a Tesla call option with a strike price of $600. The price per option is $20.95 and the expiration date is June 11th (option was bought on June 2nd). This means that the total premium is: $20.95 times a hundred, which equals $2095.
As shown by the profit/loss table, the current stock price of Tesla stock is at $605. If Tesla keeps trading for around $606 for the rest of the duration of the contract, the profit goes from +$32 all the way to -$1,495. This is due to the fact that as time progresses, if the stock price does not move, you will lose money to time decay.
Another element to be aware of is that the moment the call contract is bought, if Tesla trades anywhere lower than $603, you will be faced with losses.
And as you can see, the longer you keep the option the harder it is to be on the positive side of the trade. On June 11th, even though the contract was initially bought when Tesla was at $605, Tesla stock will need to be minimum at $621 to be a positive trade.
The profit table can be done with any stock on the following website that we suggest using when you want to calculate your risk/reward for any potential trade that you wish to make with options. www.optionsprofitcalculator.com
Call and Put Options Examples
This is an example of the interface of an option page. It can be very intimidating at first but it is actually quite simple and straightforward. On this broker’s option page, they separated the call options on the left side and the put options on the right side. In the center column, we can see all the different strike prices of $TSLA (Tesla stock). At the very top of the page, there are different dates that can be chosen as the expiration date for the contract. For this example, we chose June 18th, 2021 as the expiration date for the contract. At the moment of that screenshot, it was June 3rd, 2021. This means that the option we are going to select is going to expire in 2 weeks and 2 days.
At the very center of the image next to the ‘1’ in yellow, we notice that so far, the trading day of June 3rd, 2021, has been trading at -5.33% from the opening price. This means that the put contract has gained value and the call options have lost value. This is why the column of last price of the call options are in red and the column of last price of the put options are all in green.
Call Option Example
Using the same previous example, we are going to buy a call option at the strike price of $540 using the bidding price for one contract of $46.20. The total premium for that contract will then be $4,620 ($46.20 x 100). Here are the details of the contract:
Option type: Call Option
Cost of one contract: $46.20
Total Premium: $4,620
Expiration Date: June 18th, 2021
Strike Price: $540
Max Loss possible: $4,620
Now, let’s look at a profit/loss table independence of the stock price to better understand how this call option will react to $TSLA price fluctuation. Notice that the value removes the premium cost of the options. Therefore, the sell price of the call options needs to be greater than $4,620 to be profitable.
First things first, this table is a great way to visualize the option’s profit/loss in dependence of the stock price fluctuation. However, it can also vary depending on other factors such as increase of implied volatility. An example of this is a huge spike of call option demands due to the release of bullish news.
Second, from this table we clearly notice that the closer we get to the expiration date the higher the stock price needs to be in order to be positive on the trade due to time decay.
Third, let us say that $TSLA increased by 2.1% on June 3rd. Then our profit will be $938 if we decide to sell the contract. A profit of $938 means that the contract was sold at $5,558, which is the addition of the premium plus the profits. This is a gain of 20% on the contract even though the stock only went up 2.1%. This is the leverage we can get by trading options, but this goes for the downside as well. For -2.1% in the stock price we are at a loss of -16.41%.
Put Option Example
Using the same previous example, we are going to buy a put option at the strike price of $540 using the bidding price for a contract of $13.40. The total premium for that contract will then be $1,340 ($13.40 x 100). Here are the details of the contract:
Option type: Put Option
Cost of one contract: $13.40
Total Premium: $1,340
Expiration Date: June 18th, 2021
Strike Price: $540
Max Loss possible: $1,340
Now, let’s look at a profit/loss table independence of the stock price to better understand how this call option will react to $TSLA price fluctuation. Notice that the value removes the premium cost of the options. Therefore, the sell price of the call options needs to be greater than $1,340 to be profitable.
First things first, this table is a great way to visualize the options profit/loss in dependence of the stock price fluctuation. However, it can also vary depending on other factors such as increase of implied volatility. For example, a huge spike of put options demands due to bearish news that came out.
Second, from this table we clearly notice that the closer we get to the expiration date the lower the stock price needs to be in order to be positive on the trade due to time decay. Time decay for this put option is very aggressive compared to the call option time decay.
Third, let us say that $TSLA decreased by -2.1% on June 3rd. Then our profit will be $399 if we sell the contract. A profit of $399 means that we sold the contract for $1,739, the addition of the premium plus the profits. This is a gain of 29.78% on the contract even though the stock only went down by 2.1%. For an increase of +2.1% in the stock price, we are at a loss of -22.54%.
The profit/loss table used for the examples above can be done with any stock on the following website: www.optionsprofitcalculator.com We suggest using it to calculate your risk/reward for any potential trade that you wish to make with options.