This was back in the day when I interacted in the same physical space as other human beings. I had tried to look somewhat professional, as one does when they get a new job. (And by this, I mean I brushed my hair and wore a blouse. No matter how I do myself up, my sister tells me I permanently look like a painter anyways. Or, worse, “the girl who always looks like she’s going to the farmers market”, as characterized by my boss).
After my manager put on what I would learn to be a daily compilation video of Tom Brady yelling “Let’s GO”, the men in the office leaned back in their chairs and delved into finance-speak.
Coffee in hand, it went something like this:
Blah blah Tesla/Elon Musk bleh blah *obscure company name and some numbers* blah bleh Do you trade options? Hahahaha!
I’m paraphrasing here.
But as goes when trying to make new friends, you laugh along with them. So, I sort of laughed and also stared blankly and definitely picked at croissant crumbs on my top and then immediately vowed to write this article.
I’ve put it off for 10 months now. And even after all my research, I’m still not finding the humour in options trading. I definitely missed the punchline.
Here goes. And I mean this with as much gravity as words can hold. This is going to be a 3-week endeavour, (give or take, it depends on how succinct I can be). But I do implore you to stick with it (I wouldn’t be putting myself nor you through this hellscape if it wasn’t a viable way to make some money)…
What is an option?
A hellscape. I’m kidding. Sort of. The most distilled answer I could find:
An option is a contract you can purchase that gives you the right (but not the obligation) to buy or sell stock at a pre-set price, on or before a particular date. In other words- you have the option to do what you want with that purchased right.
You can also sell an options contract. This is where you can sell the aforementioned right to a buyer and collect a premium for it.
Confused? I hope so. At this point I certainly was.
Stocks vs Options
Who knew talking about stocks would grow to be a safe haven of sorts…
To buy a stock is to buy a small piece of ownership in a company. (If you are a Succession devotee, you know the power large shareholders of a company possess. If you are not, abruptly stop reading and go watch – I have never seen a show so effectively weaponize figurative language and no article I write will ever compare). Options, in turn, are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.
In every options transaction, there is a buyer and a seller. For every option purchased, there is always someone selling it. With buying options (contracts – just imagine the word contract after every time you read the word options), you do not immediately own a piece of the company but rather a contract to buy or sell a stock at a certain price. Think of it like dating on Hinge. Quite non-committal, never the real thing (though God knows whatever that means) and a typical expiration date of 30 days.
There are 2 types of options:
- Call options: give the option holder the right (but not the obligation) to BUY shares of stock at an agreed upon price, on or before a particular date
- Put options: same thing but flip it and reverse it. Puts give the option holder the right (but not the obligation) to SELL shares of stock at an agreed upon price, on or before a particular date
Every option has 3 main elements:
- Strike Price: Price at which shares will be bought or sold if the option buyer exercises that option. Aka, the aforementioned “agreed upon price” at which the stock will be bought or sold.
- Expiration date: The ‘particular date’ at which the option contract will expire. In other words, the date an options’ final value is determined and can no longer be traded. Most stocks have options that are expiring from a few days away to 2 years away. 30-60 days, however, seems to be most common.
- Premium: The amount of money an investor will pay for a call or put option. It is the price of the option contract, and thus the income (and incentive) received by the seller.
Mix it all together…
Hypothetical 1:
Type: Call
Strike: 120
Expiration: 30 days from now
So…owning this Call Option will allow you to PURCHASE stock…
at $120 per share (strike price) …
anytime within the next 30 days (expiration date) …
no matter where the stock price is actually at!
If this stock goes up to $135 within the next 30 days then fortunately for you, you own a call option that allows you to buy stock at $120, even though the stock is currently trading at $135. That’s a gross profit of $15 (before the premium and cap gains tax etc. – just hide all that scary stuff under the bed for an unpleasant surprise come tax season).
Hypothetical 2:
Type: Put
Strike: 120
Expiration: 30 days from now
So…owning this Put Option will allow you to SELL stock…
at $120 per share (strike price) …
anytime within the next 30 days (expiration date) …
no matter where the stock price is actually at!
If the stock tanks to $60 per share, you own a put option that gives you the right to sell stock at $120 even though the current market value is $60. Meaning, you have an astronomically better sale price than if you were to just sell stock at the current market value.
It is ok if this bit went over your head. I will explain and explain again.
Why should I care?
(I thought the same when researching – I am not one for difficult things with no pay out). But options are used for 3 main reasons, some of which may or may not interest you.
- Hedging: Think of this like a form of insurance. If you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. In finance, there is no brunette Progressive girl to buy this insurance from (shame). Instead, investors will hedge one investment by making a trade in another. Hedging is basically just a strategy employed to mitigate risk in your investment portfolio.
- Substitute: Say you’ve made a judgment about what will happen with a stock but don’t want the expense of purchasing it directly…Hi options, nice to meet you. These contracts allow you to profit from a company’s price movements without having to buy it outright. For example, you’re an Elon fan (ew), and you think Tesla stock is going “to the moon”. You’d like to profit from this but can’t afford the (wildly overvalued) $675 per share. You can instead buy a call option for Tesla for far less money than that of shares and make a profit off of their future success until the expiration date.
*This isn’t, sadly, all rainbows and glitter. There is risk associated with options and it will be explained at a later date. - Leverage: Simply put, leverage is using a small amount of money to control a large amount of a financial asset. This, similar to the substitute, deals with the idea that options allow you to play with the big kids without having to commit to a sleepover.
To be redundant:
You don’t have to own stock to trade options. You can just trade the fluctuating option prices in your brokerage account like you can trade stock. Basically, as is with all elements of the financial-verse, everything is made into a thing. I didn’t call this a hellscape for nothing.
Proud of you if you’ve gotten this far. Ask me your questions so I can answer them before Part 2.
Until next week…