Lesson 27: The Basics of Options Trading (in Plain English)
By T3 Live
Are you ready to start trading options?'
Then you're in luck.
You're about to get a 100% FREE crash course in options trading.
Contrary to popular belief, options are actually not that complicated.
And they're not inherently risky — you can take as much, or as little risk as you want.
Are you ready to start learning?
What Are Options?
Derivatives are securities which are priced based upon the price of another security, like a stock, ETF, index, or commodity.
And options are the best-known form of derivatives.
In this series, we're going to focus exclusively on options on stocks and ETF's.
Options represent the right but not the obligation to buy or sell a certain stock at a certain price by a certain date.
And as the price of the underlying stock fluctuate, those rights change in value.
A sports betting analogy can help you understand this concept.
An option is at its most basic level a bet on a bet.
You're betting that the value of the bet itself will change.
Let's say it's the start of the NFL season, and we think the Green Bay Packers will win the Super Bowl.
Options would allow us to bet that the value of a bet on the Packers to winning the Super Bowl will rise or fall.
If the Packers win their first 10 games in a row, that bet will be worth a lot of money.
But if they only win 5, it won't.
Calls vs. Puts
Call options give a trader the right but not the obligation to buy a certain stock at a certain price by a certain date.
All things being equal, when a stock price rises, the price of a call option goes up.
Therefore, the buyer of the call option wants the price of the underlying stock to rise.
Put options give a trader the right but not the obligation to sell a certain stock at a certain price by a certain date.
All things being equal, when a stock price falls, the price of a put option goes up.
So the buyer of the put option wants the price of the underlying stock to fall.
Why Even Bother with Options?
First, options require less capital to trade than stocks.
Let's assume we're bullish on Tesla.
If Tesla (TSLA) is trading at $380, it would take $38,000 to buy 100 shares of the stock.
However, we could buy a call option on Tesla for $2,000 or less, giving us exposure to 100 shares of Tesla at a low cost.
So options give you a lot more bang for your buck in terms of upside potential.
On the downside, options have a fixed expiration date.
You can theoretically wait forever for a stock to move, but an option has to move in your favor quickly. (In a future article, we'll explain the role of time in options prices.)
Otherwise, it will decline in value or expire worthless, giving you a 100% loss.
And that's just long options.
Shorting options — a practice we don't endorse — is even more dangerous, and can destroy your trading account.
And that's the trade-off: options require less capital and they have huge upside potential. But you also face serious downside risk.
Another benefit of options is that they can be used to hedge an equity portfolio or individual stock positions at a reasonable cost.
And finally, options are incredibly flexible. With options you can speculate that a stock will rise, fall, or even do nothing.
Yes — you can use options to make money if a stock does absolutely nothing. We'll be going over a strategy for this in the future.
Strike Prices and Expiration Dates
All options have a strike price and an expiration date.
If a person says “I bought NVDA $180 November calls,” they are telling you two things:
- They have the right but not the obligation to buy NVDA at $180 (the strike price)
- That right expires in November
And a person says “I bought TSLA $350 January puts,” they are telling you two things:
- They have the right but not the obligation to sell TSLA at $350 (the strike price)
- That right expires in January
Most options expire on Fridays at 4:00 p.m. ET.
Large-cap stocks tend to have options that expire every week.
Small and mid-cap stocks sometimes have options that expire only on the third Friday of each month.
The Basics of Options Contracts and Exercising Options
Most options contracts represent 100 shares.
So buying 1 call option gives you the right to buy 100 shares.
2 contracts give you the right to buy 200 shares.
To determine the dollar value of an option, take the current price and multiply it by 100.
If an option is trading at a price of $1, it actually costs $100 to buy.
As we told you above, when you buy a call option, you have the right to buy a stock at a certain price by a certain date.
Let's say we own 1 NVDA $180 November call.
This means that at any time before the November expiration date, we can buy 100 shares of NVDA at $180.
Assume NVDA skyrockets on earnings and hits $200.
We can then do two things:
We can sell the option itself for a profit.
Or, we can exercise our right to buy the stock, and purchase 100 shares for $180.
That gives us an instant profit of $20 per share, or a total of $2,000. (minus whatever we paid for the call option in the first place)
What Is an Options Contract?
Options are not like stocks, which have a certain number of shares outstanding.
Options don't actually exist until a buyer and seller come together and form a contract.
The term “Open Interest” describes the number of option contracts that are open at a particular strike an expiration date.
If we say the October SPY $250 puts have an option interest of 20,000, this means that there are 20,000 contracts currently open.
Trading Options Is a Zero Sum Game
There are two parties on every trade, and it is a zero sum game. If one side of the trade makes a dollar, the other loses it.
You know how we had the right to buy NVDA at $180 at any time until the November expiration date?
Well, there was someone on the other side of that trade that agreed to sell those shares to us at that price.
We were the long side of the trade, and they were the short.
We wanted the stock to go up and they wanted it to go down.
Why? Because again, it's a zero sum game. If we're making money, they're losing it. And vice versa!
Put options operate under the same concept, but backwards.
The buyer of the put option wants the stock to go down.
And the seller of the put option wants it to go up!
Here's a simple graphic that illustrates these relationships:
Note: there are situations where options traders can make money even when stocks don't move, but they're beyond the scope of this article. We'll delve into them later in this series!
In the Money, Out of the Money, and Intrinsic Value
All options (both calls and puts) with a strike price very close to the price of the underlying stock are said to be “at the money.”
So if AAPL is at $155, both $155 call and put options are said to be “at the money.”
Call options with strike prices below the current price of the underlying stock are said to be “in the money.”
For example, if AAPL is trading at $155, all call options with strike prices below $155 are “in the money.”
Here's why: on expiration day, the right to buy Apple at $155 only has value if Apple is trading above $155.
If Apple is trading at $160, and I have the right to buy Apple at $155, I'm a happy camper.
The concept of instrinsic value is closely related.
For in the money call options, the intrinsic value is the difference between the stock price and the strike price. If AAPL is at $160, call options with a $155 strike have $5 in intrinsic value.
If a call option's price is above the current stock price, we call it “out of the money.”
Out of the money options do not have intrinsic value.
However, out-of-the-money options are not inherently bad. They just require a big move in the underlying stock to pay off.
Here's a table showing you at, in, and out of the money options on AAPL, assuming the stock is at $155:
Let's move on to puts.
Put options with strike prices above the current price of the underlying stock are said to be “in the money.”
For example, if AAPL is trading at $155, all put options with strike prices above $155 are “in the money.”
This is because on expiration day, the right to sell AAPL at $155 only has value if AAPL is trading below $155.
If AAPL is trading at $150, and I have the right to sell at $155, I'm a happy camper.
But if AAPL is at $160 on expiration day, having the right to sell at $155 is worthless!
The concept of instrinsic value is closely related.
For in the money put options, the intrinsic value is the difference between the strike price and the stock price. If AAPL is at $155, a put options with a $160 strike has $5 in intrinsic value.
Risk & Reward
Theoretically, stocks have unlimited upside potential.
The the same goes for call options.
Let's say KITE is currently trading at $60, and we purchase a $60 December call option for $5.
If on expiration day, KITE is trading at $100 because of a takeover bid, that option will be worth $40. ($100 stock price minus the $60 strike price of our call option)
So we paid $500 for an asset worth $4,000.
That's a gain of $3,500. And admittedly, it's an extreme case. But those are the kinds of profits most traders dream about when they start playing with options.
Here's a chart showing the potential P&L for the $60 call at each stock price:
But remember what we said before about options being a zero sum game?
Our $3,500 profit was a $3,500 loss for the person on the other side of the trade. This is why shorting options is so risky – you can take enormous losses.
Now let's examine another scenario.
Let's say we bought that same $60 December call option for $5.
What if KITE is at $50 at expiration?
Well, the right to buy KITE at $60 isn't worth anything if the stock is at $55. So the option would expire worthless.
The $500 we paid for the original option turns into a $500 profit for the seller of the call option.
Now let's look at the other side with puts.
Let's say BAC is currently trading at $25, and we purchase a $25 January put option for $3.
If on expiration day, BAC is trading at $20, that option will be worth $5. ($25 strike price minus the $20 stock price.)
So we put out $300, and now have an asset worth $500.
That's a profit of $200.
But what if BAC went up, and reached $30 on expiration day?
Our option would expire worthless, and the $300 we paid for our option turns into a $300 profit for the seller of the call option.
Here's what our potential P&L looks like on expiration day with BAC:
Now, unlike call options, puts do not have unlimited upside potential.
This is because a stock can't go lower than zero.
A $50 stock can only go down $50. But a $50 stock could theoretically go up forever.