My Financial Independence Journey » Investing » A Brief Primer on Options: Part 1 (What are options?)
A Brief Primer on Options: Part 1 (What are options?)
I love options. I particularly love selling cash-secured put options. But the best place to start is the beginning. So for the purposes of this post, I’m going to walk us through the basics of options. What they are, how do they work, and why you might be interested in them.
A word of caution before we begin. Options trading can become super complicated. The more complicated the trades, the more sophisticated you need to be as an investor, the more risk you take on, and the bigger your possible losses become. And I’m talking portfolio destroyingly big here. That’s why I keep things simple and avoid crazy spreads and use of margin. Our objective is to take some small risks and build wealth, not take large risks and wreck all of our hard work.
Features of options:
- Are a type of derivative investment, meaning that they are based on some underlying security, such as a stock.
- Are standardized contracts that can be bought and sold on exchanges.
- Each option controls a standard lot, 100 shares, of the underlying security.
- Are time limited, which means that they are only valid for a certain period of time. As options approach their expiratory date, their value declines. When they expire, they become worthless.
- Have prices that are affected by the price of the underlying security, volatility, and time to expiration.
- Come in two basic flavors: puts and calls.
Option Terminology
Like most things in the world, options have their own jargon which you need to familiarize yourself with. Here’s some of the basics.
- “Writing an option” - The same thing as selling an option.
- Premium - The value of the option when sold.
- Strike price - The price of the underlying security as stated in the option.
- In the money - Calls that are below the strike price. Puts that are above the strike price. Basically, when the value of the underlying security is such that the option will expire worthless and the option seller gets to keep the premium.
- Out of the money - The opposite of in the money. Calls that are above the strike price or puts that are below the strike price.
- Assignment - Transfer of a security when an option is exercised. If you are the recipient of the security, it is said to be assigned to you.
- Cash Secured Put - Writing a put against an amount of cash that would allow you to buy the security if it were assigned to you. The cash is secured by your broker and you can’t use it for anything else. But it does generate interest, the same as it would if stuck in a bank account.
- Covered Call - Writing a call against a security that you own. When the call is active, you can’t sell the stock.
How do options work?
- If you sell a put option, you are giving someone the right (but not obligation) to force you to buy the underlying security from them at the price specified in the option.
- If you buy a put option, you are obtaining the right (but not obligation) to force someone else to buy the underlying security from you at the price specified in the option.
- If you sell a call option, you are giving someone the right (but not obligation) to force you to sell a security that you own at the price specified in the option.
- If you buy a call option, you are obtaining the right (but not obligation) to force someone else to sell you a security at the price specified in the option.
How to make money with options if you think a security will go DOWN in value
Suppose that you think, but aren’t sure, that Coca Cola (KO) is going to go DOWN in value. Here’s two options based strategies you might decide to employ.
If you sell a (covered) call option, you have given someone else the right to purchase KO at the strike price specified in the option for the duration of the contract. In exchange for this right, you receive the option premium (a fraction of the underlying security’s price). When you sell a covered call, the option premium that you receive is subtracted from your cost basis.
- If you guess correctly and KO goes down, the option expires worthless and you get to keep the premium. And you get to keep the stock. No one is going to buy a stock from you for more than it’s current value.
- If you guessed incorrectly and KO goes up, the option is exercised and you must sell the underlying stock at the agreed upon strike price. You get to keep the premium, but you lose the stock.
If you buy a put option, you now have the right to force someone else to buy KO from you at the strike price specified in the option for the duration of the contract. In exchange for this right, you pay the option premium (a fraction of the underlying security’s price).
- If you guess correctly and KO goes down, the option is exercised and you get to sell KO at the strike price rather than the much lower current value. This strategy is commonly used as insurance against falling prices. In the event that the stock’s price tanks, your loss will be limited to the option premium.
- If you guessed incorrectly and KO goes up, the option expires worthless and the only money you are out is the premium.
How to make money with options if you think a security will go UP in value
Suppose that you think, but aren’t sure, that Coca Cola (KO) is going to go up in value. Here’s two options based strategies you might decide to employ.
If you buy a call option, you now have the right to purchase KO at the strike price specified in the option for the duration of the contract. In exchange for this right, you pay the option premium (a fraction of the underlying security’s price).
- If you guess correctly and KO goes up, the option is exercised and someone is forced to sell you the stock for the lower price as specified in the option. If the price strike price plus the option premium is less than the current value of the stock, you made money.
- If you guessed incorrectly and KO goes down, you don’t exercise the option and all you are out is the option premium.
If you sell a (cash secured) put option, you have given someone else the right to sell you KO at the strike price specified in the option for the duration of the contract. In exchange for this right, you receive the option premium.
- If you guess correctly and KO goes up, then the option expires worthless and you get to keep the premium.
- If you guessed incorrectly, then you must buy KO at the strike price, but you still get to keep the option premium. If you are forced to purchase the stock, then the option premium is deducted from your cost basis.
Disclosure: I am long KO. At the time of this writing I’m not planning on buying or selling KO or options based on it.
Readers: What are your thoughts on options? Have you ever bought or sold options? Are you interested in learning how to use them? Or would you rather stick to more conventional stock picking?
Written by myfijourney
20 Responses to "A Brief Primer on Options: Part 1 (What are options?)"
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Great write-up on options MFIJ! I started getting involved with options a few years ago. I’ve not done a cash secured put, but think they can be a great tool. I’ve done covered calls, straddles, spreads and bought a few calls…though I like to do spreads, generally, the most.
Glad you liked the write up. I’ve got two more parts coming over the next couple of weeks. I’ve never tried spreads or straddles before, but I’ve been reading about them.
MFIJ,
I like your intro article on options. I started paper trading options about a year ago and went live last October. I am primarily using covered calls and will be using cash secured puts to build my portfolio. I don’t get too exotic with spreads in my live account, but I like using them in my paper account. I will get more involved in their use when I have enough capital to feel more comfortable. Keep up the good work. There is a really good website on using put selling for cash flow at http://www.fullyinformed.com Anyways, looking forward to you next couple of posts.
Daddy Pig,
Thanks for stopping by! I’m glad that you enjoyed the article. I’ve got two more in this series coming up. The biggest hindrance I’ve found to using cash secured puts is having enough cash in the account to sell them regularly. But this is mitigated if you have a margin account so long as you only want to use the puts to generate cash flow. If you want to use puts to enter a position, cash is still a limiting factor since you need to have enough cash on hand to purchase 100 shares.
Thanks for the tip on Fully Informed. I’ll check it out.
Great explanation MFIJ, I am interested in options but at this point lack the knowledge to make any option trades. I have a basic understanding, but have a ways to go before I make a trade. This post helped though, thanks!
Jim,
Paper trading can be a great way to get your feet wet in options without putting any money on the line. The next step would be to sell a put in place of a limit order on a stock you would like to buy anyway. That way you get the experience of selling a put without any real risk.
I love selling cash secured puts as well. I wish I would have discovered this strategy earlier in my investment career. Great right up and spot on. I believe all investors should learn fundamental and technical analysis, after that they should be learning options.
I’m glad you liked the article! I wish I knew about puts early on too. I have too more articles coming up in this series before I move onto something else.
Interesting. I didn’t realize this was possible. I’ve dealt with options a LOT through an employer during a boom period, but I didn’t realize I could play in the game from the outside. I will be reading up some more!
Nick,
Thanks for stopping by! Options can be a great tool to use in your investment portfolio. Read up as much as you can about them. I’ve got two more articles in this series coming out in the next couple of weeks. You could also try out paper trading to get your feet wet before investing real money. One of the best things about options is you can use them conservatively, speculatively, or anywhere in between depending on your comfort level.
I love covered calls. Great way to extract cash from a sideways market. Since you need 100 shares I only do it on the cheaper priced stocks.
I bought 2 put contracts for the first time a few weeks ago. A near the money put on LULU (Strike price is 67.50). I was right and the stock tanked but it has come back a bit. The time is June so I have a few months for it to go back down and I unload the puts for a bit of a profit.
Whenever I get more complicated than those 2 strategies I start to get confused lol
I have a hard time getting into covered calls. Not because I don’t understand them or anything. I’m just psychologically adverse to having my stocks called away. But I have been tempted to try some covered calls with some very overvalued stocks that I have.
I am also keen on selling options, puts or calls, but puts better. Selling options take one part of guessing away from decision making process. With puts you either collect the premium and repeat the process or get assigned to a stock you wanted to buy anyway at lower price. What else would you want selling puts?!? An ideal position!
Nice overview, looking forward to the next 2. I prefer selling puts to calls because most of my positions I entered in for a really good price so I don’t want them called away.
Thanks! I can’t get into covered calls for much the same reason as you. I just don’t like the idea of having my stock called away.
Options can be great for those who really know what they’re doing.
I’m really bad at buying individual stocks though, and I’m perfectly okay in knowing this. But I still love learning about investing in individual stocks and knowing how to utilize these tools is important.
I was lousy at stock picking for a while too. Then eventually I learned enough to get more comfortable at it. I’m always learning about new stuff. A couple weeks ago, I was reading about futures trading. I don’t think I’d ever try futures trading, but I feel that the more I know, the better investor I become.
[...] in part 1 of our options primer we discussed what options are and why you might want to use them. Now [...]
[...] part one, we discussed what options are and why you might want to use them. In part two, we discussed how to read an options table as [...]
Good work, keep it up.