Options Basics
Welcome to the most basic of basic options courses you’ll find anywhere. This course is a complete, end-to-end discussion of the basics of options trading. It covers the most fundamental aspects of options trades, including discussion of what options are, how to compute a profit/loss for a given trade, and a simplified view of what happens in the market when a person places an order to trade (i.e. the “mechanics” of a trade).
After reading this material you will:
- understand what options are
- know how options are categorized
- understand how to compute the profit or loss for a given option trade
- have a good understanding of a simplified view of how the market works when a trade is made
- know what it means for an option to expire, and what happens when it expires
Options Are Contracts
The very first thing to understand in any discussion of options is what they actually are. There’s a very technical definition in the terminology page, but that doesn’t describe what they actually represent, or the mechanics of how they work.
An option is a contract, as seen in the definition, but what does that mean? Almost everyone is affected by contracts in their day to day lives, even if they don’t realize it.
Contract Examples
These are all examples of contracts:
- The lease agreement you signed when renting your home or apartment
- The purchase agreement/offer signed when buying a home
- The user agreement signed when buying a new mobile phone
- The agreement signed when opening a brokerage account to trade options
Generally, a contract requires four things in order for it to be enforceable:
- Identification of the people who agree to the contract
- Specific, clearly defined obligations, rights and privileges of all the people agreeing to the contract
- An exchange of value between the parties, e.g., a renter giving the security deposit to the landlord
- The term during which the contract will be enforced (e.g. a start and end date, or a start date and a period of time)
Options are all contracts:
Identification of the parties: There are always two parties to a contract: the buyer and seller.
Specific, clearly defined obligations, rights and privileges: Option contracts always provide two rights to the buyer: a) the right to buy (or sell) the underlying stock to the seller at the strike price; b) the privilege to decide whether to exercise that right. Further, all option contracts are specified to be for exactly 100 shares of the underlying stock.
Exchange of Value: Option contracts always include an exchange of value: namely, the buyer always pays cash to the seller in exchange for generating the contract.
Term: Option contracts are always for a limited period of time, and have clear, well-defined expiration dates.
All option contracts:
- are created when the buyer pays cash, called the premium, to the seller
- give the contract buyer the right to buy (or sell) 100 shares of stock
- obligate the contract seller to sell (or buy) 100 shares of stock
- define the price of each share, known as the strike price
- expire at the end of the trading session on the expiration date
Types of Options
All options come in two flavors: call options and put options. The only difference between the types is the right granted to the buyer:
- Call options grant the buyer the right to buy the underlying stock at the strike price on (or before) the expiration date. The seller is obligated to sell his shares at the strike price.
- Put options grant the buyer the right to sell the underlying stock at the strike price on (or before) the expiration date. The seller is obligated to buy those shares from the buyer, at the strike price.
Other than these rights, options are otherwise the same: they have a price, the stock underlying the option has a strike price, and there is an expiration date, after which the option will be either be worthless, or will have been exercised.
When a buyer invokes the right the option grants, it’s called an exercise, and we say the buyer has exercised the option.
There are also two different kinds of Options with respect to how they can be exercised:
- European Options can only be exercised on the expiration date.
- American Options can be exercised any time up to and including the expiration date.
“European” and “American” don’t refer to where the options are, i.e., in Europe or America. The Chicago Board of Options Equities (CBOE), for example, lists several Options that are European style options, such as XSP.
Buying, Selling, and Writing Options
Occasionally you’ll see a phrase like “Jacob wrote a $5 TSLA CALL.” The word write in this context simply means to sell. If you see phrases like that, it means the trader sold the option rather than buying it.
There is no equivalent term for buying an option.
Out of, In, or At the Money
Often in investment material you’ll see three phrases:
- Out of the money
- In the money
- At the money
These are a shorthand way of describing the stock price relative to the option strike price.
An out of the money option is an option that would be worthless if it were to expire.
- Put options are “out of the money” when the stock price is above the strike price
- Call options are “out of the money” when the stock price is below the strike price
An in the money option is an option that would be profitable if it were to expire.
- Put options are “in the money” when the stock price is below the strike price
- Call options are “in the money” when the stock price is above the strike price
An at the money option is an option that with a strike price very close to the stock price, whether it’s above or below.
Settlement Types
When options are exercised, there are two ways to settle the option.
Physically Settled options are options that require actual shares of the stock or fund to be transferred to the option holder.
Cash Settled options are options that only transfer cash, computed as the difference between the stock price and the strike price.
Shorthand Notation
When we discuss options for a specific company or fund, we usually follow the following convention for writing the description out in shorthand.
[quantity] [symbol] [expiry] [strike] [type]
Examples
- 5 AAPL 2/21 30 PUT –> Refers to 5 February 21 PUT option contracts for AAPL (Apple) stock with a $30 strike price each
- 7 SPY 3/30 500 CALL –> Refers to 7 March 30 CALL option contracts for SPY (The SPDR S&P 500 Index) with a $500 strike price each
Bringing it Together: Example Contracts
Example 1: A CALL Option
John buys a CALL option from Cindy. The option’s underlying is Apple (AAPL). The strike price is $200. The expiry is 5/29.
Any time on or before 5/29, John can exercise the option and force Cindy to sell him 100 shares of AAPL stock for $200 per share, or $20,000 total. At the end of the trading day on 5/29, the option expires: if John hasn’t exercised his right to buy, he cannot force Cindy to sell her shares.
This works also if Cindy sells John a similar CALL option.
Example 2: A PUT Option
Dennis buys a PUT option from Helen. The option’s underlying is Tesla (TSLA). The strike price is $150. The expiry is 6/8.
Any time on or before 6/8, Dennis can exercise the option and force Helen to buy 100 shares of TSLA stock for $150 per share, or $15,000 total. At the end of the trading day on 6/8, the option expires: if Dennis hasn’t exercised his right to sell, he cannot force Helen to buy his shares.
This example is the same when Helen sells Dennis a similar PUT option.
Mechanics of an Option Trade
Like a stock trade, every option trade consists of two parties: the buyer and the seller. Unlike a stock trade, an option trade creates a new thing, the contract that is transferred.
Premium The buyer pays the seller a premium in cash, based on the price of the option. The premium is calculated by multiplying the price of the option by 100, which is the number of shares in every option contract.
The premium paid by the buyer to the seller is equal to 100 times the price of the option.
Example
- An option contract for Apple (AAPL) is listed at $2.41. The buyer will pay 100 x $2.41 = $241 for each contract, and the seller will receive this amount.
Just as with stocks, you take a long or short position with options.
- Buyers are long (also written “long the option”)
- Sellers are short (also written “short the option”)
Order Entry
When a person wants to buy or sell an option, there must be a counterparty to the trade: someone will to sell to a buyer, or someone willing to buy from a seller.
A seller enters a sell order with his broker. A buyer enters a buy order with his broker. The broker sends the list of all orders to a market maker, who facilitates the trades.
Market Makers
Options are placed on the same market as stocks, so the mechanics are similar. In practice, every option trade involves three people: the buyer, the seller and the market maker. The buyer and seller both trade with the market maker in a single transaction. Market makers typically are large institutions or brokerages with access to capital, loans, and reserves of shares that retail traders and other investors do not have. This allows them a high degree of flexibility in placing trades.
Bid-Ask Spread
Similarly to stocks, there is a bid-ask spread for options.
- The bid price is the price buyers are willing to pay.
- The ask price is the price sellers are willing to receive.
- The ask price is, for all practical purposes, always greater than the bid price, for retail traders.
-
When you buy an option, you always pay the ask price, because that’s the lowest price sellers will sell the option for.
-
When you sell an option, you always receive the bid price, because that’s the highest price buyers are willing to buy the option for.
This seems paradoxical: after all, if a buyer exists, and he “always” has to pay the ask price, why does the seller receive the bid price? The answer is that the market maker is there. Trading an option can be thought of as a two-step process:
Selling
- The seller sells the option to the market maker, for the bid price
- The market maker sells the option to the buyer, for the ask price
Buying
- The market maker buys the option from the seller, for the bid price
- The buyer buys the option from the market marker, for the ask price
Note that in either case, the market maker makes a profit, which is the difference between the bid and ask prices.
In practice it is (or can be) more complicated. But for a retail trader, the above description is good enough. Every trade you make can be made with the above understanding. The end result is that the retail trader that buys the option has the rights, and the retail trader that sells the option has the obligations. In most cases, retail traders will see the bid price when they’re looking to sell options, and the ask price when they’re looking to buy.
Lifecycle of an Option Trade
There are three periods of time that are most important to note for options:
- The date of the initial trade
- The time between the initial trade and the expiration date
- The expiration and settlement
Date of the trade On this date, the buyer buys the option from the seller. This is called opening a position. The buyer gives the seller cash, and a new contract is created that corresponds to the purchase.
Elapsed Time From the moment the contract is created, up until the expiration at the close of the trading session on the expiratio date, the option simply exists.
The buyer has three moves they can make:
- Hold the option contract, i.e., do nothing with it.
- For American style options, exercise the option contract, i.e., force the seller of the option to buy or sell shares of the underlying stock, for the strike price.
- Sell the option, effectively closing their position.
The seller has two moves they can make:
- Do nothing: they don’t hold the contract, but they have exposure because the buyer can exercise their rights at any time.
- Buy an identical contract, effectively closing their position.
Expiration and Settlement At the end of the trading session on the expiration date, the contract will expire. The price of the underlying stock determines what happens at this point.
-
Automatic Exercise: the buyer’s rights are exercised automatically if:
- For put options, the stock price is at or below the strike price
- For call options, the stock price is at or above the strike price
-
Expire Worthless: nothing happens; the option contract is said to “expire worthless” if:
- For put options, the stock price is above the strike price
- For call options, the stock price is below the strike price
There is one caveat to this. Buyers of an option have the right to instruct their broker to not automatically exercise the option. In that case, unless the buyer manually exercises it, the option will always expire worthless.
If an option is exercised (whether automatically or manually), what happens next is called settlement. This is the process where both cash and stock are transferred.
Physically Settled Options
All options for regular stocks (i.e. stocks that are issued by companies, not indexes or other funds), and for most index and other funds, are “physically settled”. What this means is that some actual shares of the stock or fund are transferred as part of the settlement.
If the option is a call, the buyer of the option “calls the stock away” from the seller. The buyer pays the seller of the option 100 times the strike price per contract, and the seller transfers 100 shares per contract to the buyer.
If the option is a put, the buyer of the option “puts the stock” to the seller. The seller pays the buyer of the option 100 times the strike price per contract, and the buyer transfers 100 shares per contract to the seller.
Settlement does not necessarily occur on the day of expiration. In fact, most of the time, settlement will occur the following trading day. For most options, expiration is always on a Friday: this means settlement occurs on the following Monday. For some options, especially high-volume stocks and index funds, there are shorter expiry options, such 1-day or even same-day (“0-day”) expiration dates. For these, settlement can occur during the week.
Cash Settled Options
A select few funds are “cash settled.” In this form of settlement, the cash difference between the price of the underlying stock/fund and the strike price of the option is transferred, nothing else.
If the option is a call, the seller of the call gives the buyer cash equal to 100 times the stock price minus the strike price.
If the option is a put, the seller of the put gives the buyer cash equal to 100 times the strike price minus the stock price.
Profit And Loss From Options
Calculating the profit or loss from a stock trade is straightforward: compute the difference between the buy price and the sale price, and that’s the profit or loss. That’s the only calculation required.
Options profit and loss calculations are more complicated for two reasons: 1) options are themselves securities that can be bought and sold; 2) options are contracts for 100 shares, and there can be profit or loss as the result of an exercise, and the premium paid or received becomes a factor.
Profit/Loss from Trading the contract
The profit or loss from buying or selling the option contract itself is the same as for stocks: simply calculate the difference between the buy price and the sell price for the option, and that’s the profit or loss.
Profit/Loss from Exercise
This section discussion Profit/Loss calculation the way you will see it in typical investment discussions. This is not actually the way an accountant would compute the profit and loss. I discuss that in more depth in the trading educational material.
The P&L calculation for when an option is exercised is more complicated because the contract itself involved an exchange of money, and the stock the contracts are for has a separate price.
There are four scenarios to consider when computing the profit and loss when an option is exercised: two from the buyer’s perspective, and two from the seller’s perspective.
Buyer Profit/Loss From a Call Exercise
The buyer of an option pays a premium when he purchases the option contracts: the price of the option times 100, for each contract. This means the buyer is “down” by the premium right out of the gate. He will only make a profit from exercise if the stock’s price is above the strike price.
If the share price at exercise is above the strike price, the owner of the option can sell the 100 shares at the market price, and buys them for just the strike price. He makes a profit on that difference. However, since he had to pay money to buy the contract, the profit is reduced by the premium.
Example A call with a $10 strike price that cost $0.10 expires when the shares of the stock are priced at $12. The owner of the call buys the shares for $10 each. This is $1000 per contract. He can sell the shares at $12 each immediately, which is $1200 per contract. So each option yields a profit of $200 ($1200 - $1000) from the sale of shares. He paid $10 for the contract (100 x the price, which is 100 x $0.10). So his net profit is $200 - $10, or $190.
If the price of the stock is not high enough above the strike price, he will have paid more premium than the difference between the stock price and strike price, and be at a net loss.
A buyer paid $1.30 for a call option with a strike price of $50. He paid $130 for the contract (100 x $1.30). On expiration day the stock is trading at $51.00.
He buys 100 shares of stock for $50 (the strike price) each, or $5000. He sells the shares for $51 each (the market price), or $5100. He made a $100 profit from the sale of the stock. Since he paid $130 for the option, he ended up with a net loss of $30.
Seller Profit/Loss From a Call Exercise
If the share price at exercise is above the strike price, the seller of the option will be assigned and made to sell at the strike price. He received the premium from selling the option. His profit or loss will depend on the price he paid for the stock that he sold the call for.
A seller bought 100 shares of AAPL (Apple) for $150 each (he paid $15000). He also sold a call for $1.50 with a strike price of $160. At expiration, AAPL is trading at $165.
The seller of the option is forced to sell 100 shares of AAPL for $160 each (the strike price). He paid $150 per share, so he earns a profit of $10 per share. His profit from the sale is $16000 ($160 x 100) - $15000 (100 x $150), or $1000.
He also collected a premium of $150 (100 x the option price of $1.50) when he sold the contract.
His net profit is $1150.
A seller bought 100 shares of AAPL (Apple) for $150 each (he paid $15000). He also sold a call for $2.50 with a strike price of $140. At expiration, AAPL is trading at $155.
The seller of the option is forced to sell 100 shares of AAPL for $140 each (the strike price). He paid $150 per share, so he loses $10 per share. His loss from the sale is $15000 ($150 x 100) - $14000 (100 x $140), or $1000.
However, he also collected a premium of $250 (100 x the option price of $2.50) when he sold the contract. This “offsets” the loss somewhat.
His net loss is $750 (loss of $1000, minus the premium collected of $250).
Buyer Profit/Loss From a Put Exercise
A Put buyer will profit off the shares if he bought the shares of stock at a lower price than the strike, or break even if he bought for the strike price. The premium he paid will reduce that profit.
A buyer owns 100 shares of SPY (S&P Index Fund) which he paid $499 each for. He bought a put option for $1 at a strike price of $500.
-
Example: SPY is trading at $499 on expiration day. The buyer breaks even: he earns $1 per share from the sale of stock for $500 that he paid $499 for, but paid $1 for the premium.
-
Example: SPY is trading at $498 on expiration day. The buyer’s net profit is $1 per share: he earns $2 per share because he sold at $500 and bought at $498, but loses $1 per share from paying the premium for the option. His net profit is $100 (100 x $1).
-
Example: SPY is trading at $501 on expiration day. The buyer has lost the $1 in premium he paid for the option, and the option expires worthless.
Seller Profit/Loss from a Put Exercise
A Put seller will profit if the put expires worthless: he received the premium from the sale of the option, and that is his profit. If the option is exercised, he may lose some money if the stock price is below the strike price.
A seller sells a put option for TSLA with a strike price of $150. He sold the option when it was priced at $2, meaning he collected $200 in premium ($2 x 100 shares for the contract).
-
Example: SPY is trading at $148 at expiration. The seller is assigned and must buy 100 shares at $150, each. He pays $15,000 ($150 x 100) for this. The shares can be immediately sold for $148 each, so he’d receive $14,800 ($148 x 100). He received $200 from the sale of the option, so his net profit is $0: $15,000 (amount paid for the assigned shares) - $14,800 (amount received from selling those shares) - $200 (option premium).
-
Example: SPY is trading at $149 at expiration. This time, the option seller receives $14,900 for selling the shares he was assigned. The resulting net profit is $100: $14,900 (sold shares) + $200 (option premium) - $15,000 (bought shares).
-
Example: SPY is trading at $140 at expiration. The assignment requires him to pay $15,000, as above. He can only sell for $14,000 ($140 x 100). He received $200 in premium for selling the option, so the net loss is $1000 - $200 = $800.
Bringing it Together: A Complete Example
Scenario
On March 30, Jamal wants to buy put options for Apple (AAPL) stock. The option is for the April 29 expiration date, has a strike price of $180, and a costs $1.82 with a bid-ask spread of $0.02, meaning the bid price is $1.81 and the ask price is $1.83.
The Trade
- Jamal enters a buy order with his broker for 10 of the $180 4/29 APPL PUT option contracts.
- Rebecca enters a sell order with her broker for 3 of the same contracts.
- Sam enters a sell order with his broker for 7 of the same contracts.
- All three brokers (and they could be the same broker) select a market maker to fill all the orders.
- The market maker pays Rebecca $181 (100 x $1.81) for each contract, a total of $543 (3 contracts times $181 each), and Sam $181 for each contract, a total of $1267 (7 contracts times $181 each).
- Jamal pays the market maker $183 for each contract (10 x $1.83), or $1830.
At the end of this process, Jamal has 10 of the put options, and both Sam and Rebecca are on the hook if Jamal chooses to exercise.
There are two possible outcomes on April 29, the expiration date of the option:
- The stock price of Apple is above $180
- The stock price of Apple is equal to or less than $180
Apple is above $180 on April 29
The option will expire worthless. Jamal won’t manually exercise, because he would have to sell 100 shares of Apple for $180 (the strike price), but it’s worth more than that so he would lose money by doing so.
Apple is at or below $180
If the stock price of Apple is at or below $180, either Jamal will manually exercise it, or his broker will automatically exercise it. Sam and Rebecca will be assigned to fulfill their obligations, because they are sellers. Jamal will sell 300 shares of Apple to Rebecca (because she sold 3 contracts) and 700 shares to Sam (because he sold 7 contracts). He does this because he receives $180 per share, even though the shares are listed on the market this amount or less–he’s receiving more for the shares than the market currently thinks they’re worth.
Settlement
In the scenario where an exercise occurs, settlement must occur. It works exactly as described in the beginner course section on settlement.
- 700 of Jamal’s shares are transferred to Sam.
- Sam pays Jamal $180 x 700, or $126000.
- 300 of Jamal’s shares are transferred to Rebecca.
- Rebecca pays Jamal $180 x 300, or $54000.
Exercises
The answers are provided with each question in the drop-down box. But try them on your own first!
-
Identify the number of contracts, the strike price, the expiration, the stock, and the option type in the trade “10 $30 5/1 BAC CALL”
-
Emily bought 3 put option contracts for TSLA (Tesla) at a strike price of $150. On the day of expiration, TSLA stock is trading at $149. Will Emily’s options be exercised or will they expire worthless? Why?
-
Keith has sold 10 call option contracts for F (Ford Motors) with a strike price of $8 that expire on April 13. Write the shorthand description for this position.
-
Reilly has sold a single call option with a strike of $15 for PGE (Pacific Gas & Electric) that expire on 7/12. On 7/3 PGE is trading at $17. Is Reilly at risk of having his PGE stock “called away” (that is, is she at risk of being assigned)?
-
NVDA (Nvidia) $800 put options have a market price of $5.27. The bid-ask spread is $0.04. What will be the price buyers will pay? What will sellers receive?
-
Quentin owns 5 call contracts for AMC (AMC Movies) at a strike price of $5. On the day of expiration AMC is trading at $5.11. If Quentin doesn’t take any action, will his broker automatically exercise the contracts? If so, what will be Quentin’s profit if he sells the shares he receives?
-
Carrie bought 3 put options for $2 each at a strike price of $200. She owns 300 shares which she paid $175 each for. The stock is trading at $199 when the option expires. Should she tell her broker to not automatically exercise the options? What if she had paid $199 for the shares?