An Absolute Beginner’s Guide to Options

What are options? Why would anybody even want to buy options?

You can think of options trading like an insurance business. 

For example, when you buy auto insurance what do you buy? 

You buy the insurance company's promise, of course!

With the insurance contract the company promises to cover the costs that are occurring as a result of accidents you’re involved in for the duration of the contract.

If you have an accident during this period, the insurance company pays the bill. If not, the insurance company keeps the insurance premium they collected from you and the contract expires.

Similar to insurance, when you sell an options contract, you do something similar to what the insurance company does: You promise to buy or sell shares of a stock at a certain price up to a certain date. In return, you receive cash from the buyer for making this promise and taking on the risk.

By purchasing this contract, the options buyer receives the right, but not the obligation, to buy or sell the shares of that stock at a certain price up to a certain date. On the other hand, If the options buyer exercises their right, the options seller has an obligation to fulfill the order. You don’t really have to do anything, the brokerage automatically takes care of the order. 

Unlike real insurance business though, there is no bullshit!

There are no hidden clauses or fineprints that you can use to escape from your obligation.

Let’s have a look at a more tangible example:

Let’s say the current market price of a hypothetical stock WYLD is $100 and some guy called Brad owns 100 shares of WYLD he bought for $50/share years ago.

But, Brad is nervous! Because all the finance Youtubers have been talking about is the biggest market crash the humanity will ever see and that’s gonna happen in the next three months! 

What is worse: their video thumbnails are full of their shocked faces!!!

If such a crash occurs he can lose all his gains and maybe more! 

But he doesn’t want to sell his shares just because a bunch of internet randos told so.

So, he buys one options contract for a small fee of $2.50/share, known as options premium, to obtain the rights to sell his shares for $90/share anytime within the next three months. Since each options contract represents 100 shares, the total premium Brad pays is $2.50/share x 100 shares = $250. 

Now during these three months, one of two things might happen:
- If the share price goes below $90, he can sell his shares to the options seller at this price to keep the rest of his profits,
- If the share price of WYLD stays above the $90 mark, the options seller doesn’t have to do anything and at the end of these three months his obligation to buy these shares expire.

If Brad decides to sell his shares, the options seller will own 100 shares of WYLD for a price of $87.50/share ($90-$2.50). No matter what happens though, the options seller keeps this $2.50/share or $250 total premium. 

Options Terms

I noticed that most of the options terminology is coming from the poker, interesting.

Let’s now look at the basic options lingo:

Each options contract has four things: an underlying, a premium(or options’ price), a strike price and an expiration date.

The underlying is the stock or the ETF the options contract is representing, nothing crazy. If you buy a single Tesla options contract, the underlying is 100 Tesla shares. If it’s a SPY contract, the underlying is 100 shares of SPY ETF.

The premium is the amount an options buyer pays to the seller to buy the contract. It’s usually expressed in per share basis. But each contract represents 100 shares so the total premium for each contract is 100x of that number. Remember Brad? The $2.50/share he paid was the premium and since he purchased 1 contract, he paid $250 of premium in total.

The strike price is the price the underlying shares can be exercised at. Again expressed in per share basis. In Brad example the strike price was $90.

The expiration date is the date the contract expires. Usually the options contracts expire on the third Friday of each month, but for stocks or ETFs that are traded in high volumes weekly or daily contracts can be found.

There are two types of options contracts: call options and put options. Going back to the example in the previous section, the type of the options contract Brad bought is called a “put option” in options trading lingo.

A Put option (put in short) gives the buyer the right but not the obligation of selling their shares at the strike price until the expiration.

Call option (call in short) is the opposite of a put. 

If Brad had bought a call option instead of a put, he would have obtained the rights (but not the obligation) to buy shares at $90/share (the strike price) from the options seller in the next three months, again for a small fee or premium. In other words, Brad would have had the right to “call” the shares away until the expiration.

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No content in this website is financial advice, it is for educational and entertainment purposes only. I'm not a financial advisor, I'm just a rando on the internet and I manage my finances according to my own goals and risk appetite. There are significant risks to investing, dividends and options trading. So, you should do your own research before making any money decisions and/or consult an advisor if necessary.