It’s been a busy life here for me juggling being a full-time student, and working part-time as a bartender on top of studying the stock market and staying up to date with it all.
For those who don’t know, I am studying Finance at J. Mack Robinson College of Business in Atlanta, Georgia.
On the topic of school, these past weeks in my Finance 4000 class, “Fundamentals of Valuation”, we have been hitting the subject of Futures and Options hard and I would like to discuss the overall concept of them, mostly options since I am a Robinhood trader, and options have recently been made available for me and I assume a lot of you all who also use Robinhood.
Options trading is a really good tool to have in your trading arsenal along with regular stock trading, here’s why:
- With options… you can trade larger stocks/ETFs without having to pay the full price for them. e.g. S&P 500, AMZN, GOOG, …
- You can also “short” a stock using options trading on Robinhood. It’s not exactly like shorting compared to other platforms, but you can make a profit when the price of a stock goes down.
- You can protect your stock from volatile movements to the downside, by using options trading. This is called hedging.
- And for the advanced option traders, there are many strategies in options trading like spreads, straddles, strips, straps, and strangle.
I want to keep this post short, so I’ll first explain the concept of buying options in this post.
Each option is a contract.
There are 2 types of options: Call option contracts and Put option contracts, and each call or put option contract is 100 shares of whichever stock the option is.
Call option: You have the right to BUY (a 100 shares).
Put option: You have the right to SELL (a 100 shares).
What does this mean in simpler terms? If you think the stock is going to rise in price in the foreseeable future, you would want to buy a call option. Vice versa, if you think the stock is going to drop in price in the foreseeable future, you would buy a put option.
Options are contracts, which mean they have an expiration date and an action that must take place on the expiration date, hence the right to buy/sell.
Let’s take FB as an example, today’s 4/4/18 closing price for FB is $159.73.
There are $160, $157.50, $155, and many more call and put option prices. These prices that are close to the stock price are called the strike price or exercise price.
Say you are bullish on FB, believing within the foreseeable future, FB will rise and break $160, buy a $160 call option. If the price of the stock goes above $160, your option contract will hold a positive value.
If you’re bearish, believing within the foreseeable future, FB will drop, and break below $155, buy a $157.50 put option. If the price of FB goes below the strike price of the option, your option will hold a positive value.
This begs the question, why does it have a positive value when the stock rises above the strike price on a call option, and when the stock drops below the strike price on a put option?
Well, remember you have the right to buy when you hold a call option, and the right to sell when you a hold a put option.
When you hold an option contract, you can do 1 of 3 things:
- Sell the contract
- Exercise the contract
- Let the contract expire
Let’s focus on #2 as I explain why your contract would hold a positive value if the stock price went up when you hold a call option, and if the stock price went down when you hold a put option.
Say you bought a $160 call option on Facebook, and Facebook went up to $200 before expiration date. You have a contract that states, you have the right to buy 100 shares of FB for $160 each. Meaning if you do exercise the contract, you will be buying 100 shares of FB for $16,000, and then flip it on the market to sell for $20,000 ($200 x 100). This is why a call option holds positive value when the stock price goes above the strike price.
Now if you bought a $155 put option on Facebook, and Facebook went down to $100 before expiration date. You have a contract that states, you have the right to sell 100 shares of FB for $155. So if the contract is exercise when FB is at $100 a share, your broker would buy 100 shares of FB for market value at $100 a share, and exercise the put contract to sell 100 shares of FB at $155. This is why a put option holds positive value when the stock price goes below the strike price.
For most people, the general strategy is not to exercise these contracts or let them expire, as when they expire, they will be exercised (if they hold a positive value), but simply trade these options back and forth based on the intrinsic value of the options for a gain.
So far, we have covered strike/exercise price, now there’s 2 other prices in options that are easier to explain, the break-even price and the option cost price.
Simply put, the break-even price is the price where the stock price must hit for you to break even after you’ve purchased the contract(s).
The option cost price is simply the price for the option x100, since each contract is a 100 shares, so the multiplier is 100. Right now, a $160 call option for FB is $0.51 on my screen today after closing (4/4/18). So the total cost for 1 $160 call option is $0.51 x 100 = $51.
Isn’t that cool? You’re getting to play around with 100 shares of FB that is worth roughly $16,000 for only $51, I think that’s pretty cool.
So to recap on this $160 call option on FB for $51, the break-even price is $160.51, and FB’s share price is $159.73. If FB sees an increase in price above $160.51, you’re making a profit, if the call option hasn’t expired yet of course.
A few things to note:
- Out-of-the-money is when the stock price is below the call price, or when the stock price is above the put price (depending on which contract you have). So if you’re out-of-the-money when the contract expires, nothing happens and the most you can lose is what you paid for the contract.
- In-the-money is when the stock price is above the call price, or when the stock price is below the put price. If your option contract is in the money when it expires and you have taken no action, it will be exercised.
- There’s another factor called time decay.
- Time decay means as the expiration date of an option contract approaches, the result of the contract is easier to predict, making the value of the option contract decrease as time goes on.
I apologize if this post is a little long winded, I tried to keep it short, but at the same time I wanted to make sure I can thoroughly explain this concept of buying call and put options to someone who doesn’t have a clue what options even are.
I hope you’ve enjoyed this post, and I plan to post more in the foreseeable (; future with more information on options trading as I too am learning myself.
Questions, comments, and advice are welcomed.
Catch ya later!