While many people will tell you that options are incredibly complex and difficult to understand, that usually stems from not understanding the characteristics and terminology associated with options. They’re really quite easy once you understand what options allow you to do. So this course is going to start at the very beginning and answer the most important question: What is an Option?
Options are simply legally binding agreements – contracts – between two people to buy and sell stock at a fixed price over a given time period.
That’s really all there is to it. Rather than buy or sell shares of stock at a certain price today, you can buy an option and acquire the right to buy or sell shares of stock for a fixed price in the future. It’s that little word “right” that creates big differences for investors. Options allow you to lock in a purchase price or selling price today without having to actually buy or sell shares of stock. Whether you are controlling a purchase price or selling price depends on the type of option you purchase so let’s now look at the two types of options available.
Two Types of Options
There are two types of options: calls and puts. A call option gives the owner the right, not the obligation, to buy stock at a specific price over a given time period. It gets its name from that fact that the buyer has the right to "call" shares of stock away from another person.
A put option, on the other hand, gives the owner the right, not the obligation, to sell shares of stock at a specific price over a given time period. The buyer has the right to "put" the stock back to the owner.
Option buyers have rights to either buy stock (with a call) or sell stock (with a put). That means it is the owner’s choice, or option, to do so and that’s where these assets get their name.
Calls and puts are the building blocks for every option strategy you will ever encounter. While the above definitions of each may sound complicated, we’re going to show that you’re already familiar with their mechanics. If you don’t believe it, take a look at the following pizza coupon:
Whoever is in possession of this pizza coupon has the right to buy one pizza. It is not an obligation. How much will you pay for the pizza if you decide to use the coupon? That’s clearly stated and shows a fixed price of $10. No matter how high the price of pizzas may rise, your purchase price is locked at $10. The coupon also shows there is a fixed time period, or expiration date, for which the coupon is good.
Now let’s go back to our definition of a call option and recall that it represents:
1) Right to buy stock
2) At a fixed price
3) Over a given time period
You can see the similarities between a call option and pizza coupon. If you understand how a simple pizza coupon works, you can understand how call options work. Of course, pizza coupons are handed out for free while call options cost money. But aside from that they are conceptually the same.
Also notice that the pizza coupon specifies how many pizzas you can buy. In this example, it allows the user to buy one large pizza. Options also specify how many shares you can purchase with each contract. When options are first listed, they control 100 shares of a particular stock, which is called the “contract size.” It’s possible for that number to change due to stock splits, mergers, or other corporate actions. We’ll talk more about the contract size later in the course but, for now, just understand that each option contract generally controls 100 shares of a particular stock.
Put options, on the other hand, are similar to your car insurance. When you buy an auto insurance policy, you are not betting that you’ll wreck your car. Instead, you hope the policy will “expire worthless” and that your car will provide service for another year. However, if you should total your car, you can always submit a claim and “deliver” the wrecked car to the insurance company. In exchange, they send you cash.
Put options work in a similar way. If you buy a put option, you are buying price protection for 100 shares of stock. The reason is that you are locking in a potential selling price. It is a “potential” selling price because, remember, you are not obligated to use the put option. Therefore, if the stock price stays the same or rises, you can just let the put option (insurance policy) expire worthless and continue to hold the shares.
However, if the stock price falls substantially, you may elect to use your put option and sell your shares for a fixed price. You have the right to “put” stock back (sell it) to someone else in exchange for cash. Remember, if you buy a put option, you have the:
1) Right to sell stock
2) At a fixed price
3) Over a given time period
The mechanics of call and put options are identical but they control opposite sets of transactions. Call buyers have the right to buy shares of stock; put buyers have the right to sell shares of stock.
We just discovered that option buyers have the right to buy shares of stock if they own a call or sell shares of stock if they own a put. At this point, it should be emphasized that you do not ever have to purchase shares of stock with your call option nor do you ever have to own shares of stock in order to buy a put option. Instead, most investors and traders just buy the call or put and then sell it if the value of that option rises.
The mechanics of profiting from options is identical to the way you profit from investing in any asset. Whether it’s a share of stock, house, antique lamp or rare painting, you make a profit by selling it for more than you paid.
The same idea works for options. If you buy an option and the value rises, you can simply profit from selling the option for more than you paid. We’ll learn more later about why options rise – or fall – in value. The main points you need to understand for now is that if you buy a call you are never required to own shares prior to buying the call nor are you required to buy shares of stock in the future. If you buy a put, you are never required to own shares prior to the purchase nor are you required to sell shares of stock in the future.
Remember, if you buy an option, you have rights, not obligations. Most investors and traders simply profit from options by purchasing and selling the option.
You’ve just been introduced to buying calls and puts. At this point, you’re probably wondering who is selling them. After all, if you buy an option, someone must be selling it. The answer is that other option investors or traders will sell options. It turns out that you can enter into an option contract by either buying it or selling it. You know that you have rights if you buy an option. What happens if you sell an option?
If you sell an option, you receive cash in exchange for incurring some type of obligation. Sellers have an obligation to fulfill the contract if the option buyer decides to use their option. This is easy to conceptualize if you think about the agreement with your auto insurance company. If you buy an auto insurance policy, the insurance company does not physically sell you anything. No product is delivered to your door. Nothing changes hands except their agreement to accept an obligation (insure your car) in exchange for cash.
This is exactly what happens when investors or traders sell an option. They do not necessarily have physical “options” in their account to sell. Instead, by selling an option, they are really entering into an agreement to accept some type of obligation in exchange for cash.
What are the obligations of option sellers? That’s easy to figure out once you realize that the seller’s obligation is exactly the opposite of the buyer’s right. For example, the call buyer has the right to buy stock. Therefore, the call seller must have the obligation to sell stock. The “obligation to sell” is exactly the opposite of the “right to buy.”
If the put buyer has the right to sell stock, the put seller has the obligation to buy stock. Once again, the “obligation to buy” is exactly the opposite of the “right to sell.”
The following chart may help you visualize the rights and obligations of the buyer and seller. Notice that once we match a buyer with a seller that “rights and obligations” are on opposite sides (shown in green) while “buy and sell” are on opposite sides (shown in red):
These obligations should really be thought of as potential obligations since the seller does not know whether or not the buyer will use their option. Remember, it is the buyer’s right to decide whether or not to use the option and not a requirement. However, if the buyer decides to use his option, the seller must oblige.
Let’s run through a couple of examples to make sure you understand. If you sell a call option you may have to sell shares of stock for a fixed price, which is different from saying that you will definitely sell shares of stock at that price. (You will definitely have to sell shares of stock if the call buyer decides to use their call option and buy shares of stock.)
On the other hand, if you sell a put option, you may have to buy shares of stock for a fixed price. Again, this is very different from saying you will definitely buy shares of stock at that price. (You will definitely buy shares of stock if the put buyer decides to use their put option and sell shares of stock.)
Earlier we said that option buyers are not required to have shares in their account ahead of time nor are they required to purchase (or sell) shares of stock in the future. This may not be true for option sellers. For example, if you sell a call option, you have the potential obligation to sell shares of stock. And since there’s no way to tell how high those shares may be trading, it might be a good idea to have the shares in your account prior to selling the call.
Technically, you are not required to have the shares but you would have to, instead, deposit with your broker a sum of money called “margin” that is a good faith deposit that you will in fact have the money to buy the shares if needed. If the share price rises, you may have to deposit more money. The point is that option sellers have potential obligations and that changes things. The mechanics and risks are different for the seller.
As a side note, this doesn’t mean that you’re better off to always be the buyer. While it’s true that option buyers have the distinct advantage of deciding whether to buy or sell shares of stock, they must pay for that right. Option sellers have the disadvantage of accepting a potential obligation. However, they get paid to do so.
No Additional Benefits
If you buy an option, you are only buying rights to buy or sell shares of stock. That’s it. There are no additional benefits. For example, if you buy a call option, you will not receive dividends or be able to vote for the next officers of the company. (Of course, you could acquire stock by using your call option and thereby get dividends or voting privileges.) But by themselves, options convey nothing but an agreement between two people to buy and sell shares of stock.
In case you’re wondering, option buyers do participate in stock splits, mergers and other corporate actions. But these are not “benefits” of owning shares; they are merely ways of repackaging the company. For instance, if you own 100 shares and the stock is trading for $50 then you have $5,000 worth of stock. If the company does a 2:1 split tomorrow, you will have 200 shares valued at $25, which is still worth $5,000. The split didn’t really benefit you as a stockholder any more than it does when you get two $10 bills in exchange for a $20.
Corporate actions such as stock splits, mergers, and acquisitions cause adjustments to option contracts to ensure the option values are fair based on the new corporate structures.
The important point to remember is that options are not an alternate form of stock issued by the company. They are just agreements created between you and other investors to buy or sell shares of stock. Before we leave this section, let’s quickly compare and contrast options and stock:
How Are Options Similar to Stocks?