Options Basics (Introduction)

In this post you will be introduced to the world of options investing. Not the kind of options you have when you go to your local restaurant. These are financial products designed to be extremely useful especially when you have shares with an existing company.

These are some of the terms that will be covered:

Calls, Puts, Contract, Premiums, Strike Price, and Expiration Date.

Since this can easily be over whelming for beginners, call options are what will be be focused on the most in this post.

You buy a call if you think that a stock price will increase. This call option gives you the right to purchase 100 shares of the company. You buy a put if you think that a stock’s price will decrease. This will give you the right to sell 100 shares.

An options contract gives the investor the right to buy or sell shares in the future. A premium is the amount paid for these contracts. Every contract comes with two fixed constraints including:

1. Strike Price: This is the fixed price for the call option contract. This is the price for 100 shares if the contract is executed. For calls, the further above current stock price, the cheaper contract premiums are. Vice versa when you purchase a contract with a strike price below the current price.
2. Expiration Date: This is when the contract expires. The contract is over. Done forever. It’s important to understand how this effects the premium paid for this contract. For calls, if the share price of the company is lower than the strike price, the contract expires worthless and you won’t be able to execute that contract. If the share price is above the strike price, then the contract executable and your initial premium investment may have even gone up in value.

Lets use a made up company and call it bananas. After careful analyses, you have determined that bananas will be going up in value in 1 year.

The current price of bananas is $100.

The contract we are buying has a strike price at $110 and expires one year from now.

Now here are three outcomes with this options play.

A. Banana sky rockets to $150 before the expiration date. This also results in the call premium to go up in significant value. You have two choice.

1. Sell the contract for a profit
2. Execute the contract for 100 shares of bananas for the strike price ($125 a share)

Choosing either is a win. At the same time other factors do exist that will help you make a decision. Something I will cover in the future.

B. Banana does not go up or down. It moves laterally for the whole year. This is not an ideal outcome but certainly not the worst. The best thing to do in this situation is have a stop loss for your contract. If the value of your premium falls below your stop loss. It’s time to close your position.

C. The last outcome is the worst and can be devastating if you do not have proper risk management. Banana goes on a nose dive and loses 50% of its value. This will effect the price of the contract premium by more than 50%. potentially losing more money. A way to avoid this loss is by buying

The interesting part about the options world is that only a small fraction are actually executed and converted to 100 shares. Most investors choose to close their position by selling the contract itself for a profit or …. loss.

This is just the peak of the iceberg in options investing. Wait till you learn about executing different strategies like covers, spreads, iron corridor, credits, debits. Many of these techniques are also different depending on the length of the options contract.

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I hope you were able to learn something, thanks for your time and I hope you have a good one. Bye!