Options are very hard to explain, and for absolute beginners, they’re very hard to understand. However, after you get over the initial hump of being introduced to these derivatives, they become incredibly easy to understand—and imminently powerful.
The real difficulty is in explaining, because there are two kinds of “prices” going on. But at their core, options are very simple and basic agreements—which is why they’re so easy to create and sell.
Firstly, options can be placed on any investment, but to make things easy we’ll talk about options relating to common stocks. To illustrate options, let’s use Apple (AAPL) as an example.
As I write, Apple shares trade for about $171 per share. Let’s say that I think Apple shares will rise to $200 by January 19, 2018. I can buy 100 shares of Apple, hold them until January 19, and wait to see if the price rises to $200.
With options, I can express my opinion and earn extra money at the same time. I can write a simple contract with the following stipulation:
I agree to sell 100 shares of Apple on January 19, 2018 at the price of $200 per share.
That becomes my contract, which in finance is known as a “call option”. In short, a call option is a contract in which the person who writes the contract agrees to sell a stock at a future date at a specific price.
I then can find someone to sign that contract with me—in essence, they are agreeing to buy my 100 shares of Apple on January 19 at $200 per share. If we make an agreement and both sign the contract, we have agreed that I will sell those shares at $200 per share regardless of the market price at that time.
Now, I have taken on an extra risk. What if Apple shares go over $200 per share by January 19? I’ll be selling my shares lower than the market price, since I’m bound by the terms of the contract. To compensate me for that risk, the person who goes into the agreement with me needs to give me some money. This is known as the option premium.
In the options world, you sign contracts to agree to sell or buy shares in lots of 100 shares each. So I can write this contract—in other words, I can sell a single call option—to cover 100 shares. Let’s say I sell the contract for $1.00.
Since the contract applies to 100 shares, I am getting $100 (multiple $1.00 per contract by 100 shares covered by the contract). The buyer of the call option gives me $100, I give the promise to sell my shares on January 19th at $200 per share.
If Apple is lower than $200 per share on January 19, the call option is worthless. The buyer of the contract can still exercise the contract and buy the shares, but if he does, he’s buying at a premium to its market value. No one does that. So the contract will expire worthless, I get to keep the $100 that I sold the call option for, and I keep my shares.
If Apple is at $200 or above (in reality, only if it’s above), the buyer can exercise the contract and I’m forced to sell at $200 per share. I’ve sold my shares, the option buyer has bought them, and I also keep the $100 that I sold the option contract for.
Put Options
Put options operate in the same way, but in reverse.
Let’s say I have $20,000 in cash and I think Apple will be $200 per share on January 19. I can then write a contract which says the following:
I agree to buy 100 shares of Apple on January 19, 2018 at the price of $200 per share.
This is known as a put option. It’s the same idea as the call option, but in reverse. I’m agreeing to buy the shares regardless of the market price at a fixed period of time. If shares are less than $200 per share, I’d lose money by exercising the option, because I’m buying above market value. So if shares are more than $200, I have agreed to buy at a discount—so if I exercise the option, I get instant profits.
Buying and Selling
The confusing thing about options is that you have buyers and sellers. You can buy call options (bullish view), sell call options (bearish view), buy put options (bearish view), and sell put options (bullish view). This creates a lot of confusion, but the more an investor reads about options, the clearer the distinctions become. The important thing to remember is that an option is a contract in which the two sides agree to buy and sell an asset at a specific time at a specific price. The details of options, and the extra complexities with options in real financial markets, get easier once those fundamentals are stuck in your mind.