In this lesson, you will be introduced to options trading basics. You will learn about the different types of options and how they work. This is a very important lesson as you will need to know what kind of options exist and other basics for the upcoming lessons. Therefore, please take your time and go through these options trading basics carefully. Rather go through certain parts multiple times than continue without understanding everything.
Check out the following video lesson in which I cover all the options basics. For the best learning effect, you should watch the video lesson and read the article.
Calls and Puts:
There are two main types of options: Call Options and Put Options. Call options give their owner the right to buy the underlying asset for a certain predetermined price. The owner of a call option usually hopes the price of the underlying asset will increase in price as he then can buy this asset at a discounted price. But note that the call option’s owner has the right and not the obligation to buy the underlying asset. If he is not interested in owning shares of the underlying asset, he does not have to buy the underlying asset.
Put options give their owner the right to sell the underlying asset for a certain predetermined price. This means the owner hopes for a decline in the underlying’s price. If the underlying’s price decreases in value, the put option owner would be able to sell the underlying asset for more than it is sold for on the open market. But again, the put option owner only has the right to do this, meaning he is not required to do so.
Buying options is also known as ‘going long’.
Besides buying to open option positions, you can also sell to open an option position. This is also referred to as ‘shorting’ or ‘going short’. There is a significant difference between buying to open and selling to open. Option sellers (also known as ‘option writers’) don’t have the right, but the obligation to buy/sell shares of the underlying asset if the option buyer chooses to exercise his right to receive/sell shares for the predetermined price. As this is the case, option sellers don’t have the same directional assumption as option buyers.
A seller of a call option wants the underlying price to go down and a seller of a put option wants the price to go up.
I will try to simplify this concept with two brief examples now:
- Christian buys a call option on the stock XYZ. Thomas sells this exact option to Christian. As Christian bought the call option, he has the right to buy a certain amount of shares of XYZ at a predetermined price. If Christian chooses to exercise this right, Thomas won’t have a choice. He will have to sell shares of XYZ to Christian. Christian wants the price of XYZ to go up so that he can buy the shares at a lower price. Thomas however, wants XYZ’s price to go down or at least stay the same so that it won’t be worth it for Christian to exercise his right.
- Emily chooses to sell a put option on ABC and Oliver buys this put option. Now Oliver has the right to sell a preset amount of ABC’s shares at a certain price. Emily does have the obligation to buy these shares of ABC at the certain price if Oliver chooses to use his right to sell ABC’s shares. Oliver would only exercise his right if the stock price would decrease as he otherwise would sell the shares for less than they are worth in the open market. Emily on the other hand, hopes for an increase in ABC’s price.
As you probably have noticed by now, I mentioned a certain predetermined price multiple times. When buying or selling options, you will have to choose a price to sell/buy the underlying asset for. Once again, I will explain this with a quick example:
- Let’s say you buy a call option on stock XYZ. When buying that call option, XYZ is trading at $100. You choose the strike price 105. A strike price of 105 means that you, as a call option owner have the right to buy 100* shares of XYZ at $105. Obviously, this is not worth it if XYZ’s price stays at $100 as $105 is a higher price than $100. But if XYZ’s price rises to $120, it would definitely be worth as you could buy 100* shares of XYZ for $105 (per share) instead of $120 (per share).
(*1 standard option contract controls 100 shares of the underlying asset.)
When buying options, you will always have to choose a strike price. Most big and well-known assets will have plenty of strike prices to choose from. Depending on what strike price an option has, the option will be called differently.
If the strike price of a call option is lower than the price of the underlying asset, the option will be considered In The Money (ITM).
If the strike price of a call option is greater than the price of the underlying asset, the option will be considered Out of The Money (OTM).
If the strike price of a put option is lower than the price of the underlying asset, the option will be considered Out of The Money (OTM).
If the strike price of a put option is greater than the price of the underlying asset, the option will be considered In The Money (ITM).
If the strike price of an option is close to the underlying asset’s price, it is considered At The Money (ATM).
Of course, the prices of these options are adjusted according to their strike prices to avoid arbitrage opportunities. But more about that later.
One significant difference between most other asset classes like stocks and options is the fact that options have an expiration date. You can’t just buy an option and hold on to it forever like you could with stocks. When opening an option position, you will have to choose a strike price and an expiration date. There are plenty of different expiration dates to choose from. You can trade options for the very short-term, the long-term and everything in between. For example, you could buy/sell options that expire in one or two days. Alternatively, you could open option positions in options that expire in a few years.
Different expiration cycles exist: quarterly, monthly, weekly… Usually, the monthly expiration cycles are the most popular ones.
American vs. European Style Options (Exercising Options):
There are two different option styles: American and European. The names don’t have anything to do with the geographical locations meaning that American style options aren’t only traded in America and European options aren’t only traded in Europe. The only difference between these options is the time when they can be exercised (so when the right to buy/sell shares of the underlying can be used). American style options can be exercised whenever the option owner chooses to. European style options, however, can only be exercised on the expiration date.
Note that exercising options has nothing to do with opening and closing option positions. Long option positions can always be sold to close and short option positions can always be bought to close. This means you can also trade options similarly to stocks (selling option positions for more than you originally paid for them)
To recap things, I want to give you a few more examples of options:
- 1 Long Call 55 Jul 20 (Underlying: EFG): The 1 stands for the number of contracts. ‘Long’ means that this option is bought. Call indicates the option type. 55 is the strike price. ‘Jul 20’ indicates the expiration date (20th of July). Buying 1 contract of this option gives the owner the right to buy 100 shares of EFG at $55 before the end of the 20th of July.
- 3 Long Put 460 Apr 20 (Underlying: ABC): Buying 3 contracts of this option gives the owner the right to sell 300 shares of ABC for $460 before the end of the 20th of April.
- 10 Short Put 110 Sep 21 (Underlying XYZ): Selling 10 contracts of this put option, could lead to the obligation to buy 1000 shares of XYZ for $110. The seller of the option has to buy these shares for that price if the buyer of that option chooses to exercise his options.
- 1 Short Call 55 Jul 20 (Underlying: EFG): Selling 1 contract of this call option, potentially gives the seller the obligation to sell 100 shares of EFG for $55. This depends on what the buyer of this option does. If he exercises his option, the seller will have to sell the shares.
The Option Chain
The Option Chain is a table where everything I described above is displayed. Below, you can see a Nasdaq option chain for Apple. On the left-hand side, you can see all the call options and on the right-hand side, you can see the put options for the selected expiration date. On the top, you can see the selected and select other expiration dates. In the middle, you can see the strike prices next to the ticker symbol of Apple (AAPL). The color shift about half-way through indicates the ATM (nearest strike prices to the current price of Apple) options. Other typical displays for an option chain are the Open Interest, Volume, and Bid and Ask Price. If you don’t know what these measures are, don’t worry. We will be discussing this in a later lesson. Most option chains are fully customizable meaning that they can display whatever you want to have displayed (things like Greeks and Implied Volatility, but more on that later).
Note that the prices of the options below all are under 14 $. This is the price for an option controlling one share of the underlying asset only. But options normally control 100 shares of the underlying asset. So you always have to multiply the price displayed on an option chain by 100 to get the ‘real’ price.
I know that it can be very hard to grasp all the information at once. Most people first need some time to process everything. To help you do so, I created this short cheat sheet. I have summed up some of the basic options concepts on it. Back when I started to learn about options, I found this quite confusing and had trouble distinguishing the various option types.
To download this helpful cheat sheet either click here or the picture below.
I really hope that this brief introduction to options could give you a basic understanding of options. If you have any questions regarding the information above or anything else, feel free to comment and ask questions below.
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