A simple introduction to options

A stock option is a contract that gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. They are usually used to hedge a position but more and more investors discover the potential of stock options to be used in a leveraged investment or trading them for consistent income.

There are two types of stock options: The call option, which gives the right to “call” (buy) a stock at an agreed-upon price and date and the put option, which gives the right to “put” (sell) a stock at an agreed upon price and date.

A bit of history

The first mentions of a financial instrument similar to today’s stock options already came up in the fourth century when a philosopher and mathematician traded the option to use the limited amount of olive presses when he predicted a vast olive harvest in his region. He paid the owners of the olive presses a premium to have the right to use the presses at the time of the harvest. When indeed the harvest turned out to a significant demand in olive presses, he sold the right to the farmers who needed them for a sizeable profit. The first call option was born.

Later in the 17th Century, options were used by tulip wholesalers to hedge their buying-prices in case the harvest would turn bad and prices would shoot up. The unregulated nature of these trades led to a lot of losses and wiped out nest-eggs.

Only in 1973 the Chicago Board of Options Exchange (CBOE) began trading and the regulated options marked as we know it today came into existence.

Understanding options

Next to the type of options we also have to distinguish between American style options and the less common European style options. American options can be exercised at any time between the purchase and the expiration date, whereas European options can only be exercised on the expiration date.

The expiration date

You can think of a stock option like an insurance (against falling or rising prices) and the expiration date marks the end of the validity of your insurance. The time until the expiration date also influences the value of the option, which we will talk about a little later. The option can either be exercised on or until the expiration date and thereafter the option will be worthless.

The strike price

The strike price is the agreed-upon price you can buy or sell the underlying stock for. Once the stock goes below the strike price of a put option, the option is called “in the money”. Once the stock goes above the strike price of a call option, the option is called “in the money”.

Contracts

Options are traded in contracts, which always control 100 shares of the underlying stock. This means, that if an option is listed with a price of $1.06, you will have to pay $106 for 1 contract to control 100 shares.

Premium

The price of an option is called premium. The premium is paid to the option seller that provides you with the desired contract. You can sell options yourself without first “owning” them. You simply have to secure the position with either cash or stock of the underlying that you own. This enables you to collect premium for giving someone else the option to buy or sell at a specific price.

The value of an option contract

The best known method for stock option pricing is the Black-Scholes model. Since these methods are rather complicated, we will not go into much detail here. The important thing are the factors influencing the price of an option:

• The price of the underlying stock
• The time until the expiration date
• The volatility of the underlying stock

When the price of the underlying rises, the more likely it is that the price of a call option rises as well and the price of a put option falls.

Trading options

As we have seen before, you can both buy and sell options and you trading partners are usually other investors on the exchange. This s quite similar to stocks. Whenever you enter a trade, the broker/exchange has to ensure that both parties can hold up their end of the trade. This is also the reason why on most brokers you have to “protect” your position with a certain amount of cash/equity when entering an options position. The amount depends on the risk of the position.

Understanding the risk

Depending on your strategy there can be different amounts of risk associated with a trade.

For example selling a “naked” call option has theoretically an unlimited amount of risk, since there is a possibility that the stock price will rise an unlimited amount and at expiration date you as the seller (if you do not already own 100 shares) will have to buy 100 shares at market price, turn around and sell it for the strike price of the option.

You can also cover your position in several ways:

• If you are selling call options for a stock that you already own, you are not exposing yourself to an unlimited amount of risk, you are merely capping the possible gains on the stock position.
• You can buy another call option further out of the money. As an example when you sell a call option with a strike price of $100,— and buy a call option with a strike price of $105,— you just have to cover the difference in case of a loss and you keep the difference in premium. Here we speak of a limited-risk position.

Another example would be selling a “naked” put option. The risk on this trade is limited, since the price of the stock can only go to zero. In this case your maximum loss would be the strike price times 100 for one option contract minus the collected premium.

You also can cover naked put positions:

• If you are selling a put option for a stock that you would like to own, you can just hold enough cash in your account to be able to buy 100 shares. In case your option expires in the money, the cash will be used to buy the shares at the strike price.
• You can buy another put option further out of the money and cover your position, just like we did in the example with call options. You sell a put option with a strike price of $100,— and buy another put option with a strike price of $95,—. Now you only have to cover the difference.

Trading options for consistent income

The following strategy is based on my experience and may not work for every trading style. I found it quite useful and it provides a good income by collecting premium.

The wheel (my go-to strategy)

This is probably the simplest of all strategies and less risky than others.

Part 1

• Step 1: Pick a stock that you want to own for the current price, preferably with a stock price that you can easily afford to buy 100 - 200 shares.
• Step 2: On a down day, sell a naked at the money monthly put option, which has its expiration date around 30-45 days out. By selling the option contract, you collect the premium. This completes the first half of the wheel.
• Step 3a: If your option expired out of the money, you collected the premium and repeat the first half of the wheel (Step 1).

Part 2

• Step 3b: If your option expires in the money, you will be assigned 100 shares of the company at the strike price you selected. But you are now actually getting it cheaper, because you also collected the premium.
• Step 4: You now own 100 shares of the underlying stock and you now sell a covered call slightly out of the money or at the money (preferably above the strike price of your put option from the first half of the wheel). You again collect premium for this trade.
• Step 5a: If your contract expires out of the money, you collected the premium and start again with the second half of the wheel (Step 3b).
• Step 5b: If your contract expires in the money, your shares will be called away but you keep the premium. Now you can start the wheel over again (Step 1).

I strongly encourage you to play around with options and read further on the matter, then come back and let me know your favourite option strategy.

LEAPS

LEAPS (Long Term Equity Anticipation Security) are basically options with an expiration date fare in the future, mostly more than a year. You can use these to construct a poor man's covered call, which is basically the second part of the wheel without the need of owning 100 shares of the underlying stock. These leaps should have a delta close to 1 (100), which enable you to use them as security for selling covered calls.

Brokers

To make your life easier when dealing with options, you should choose one of the brokers, that specialise or at least provide a proper interface for option trading. This will give you the proper overview on your positions and therefore increases your chances for success.

You can check out one of the following: TastyWorks, Interactive Brokers, Thinkorswim.

Keep on reading

In case you want to read more on how to invest / trade in the stock market, I compiled a little reading list on my blog.