Options contracts | Types, simple explanations, examples

 

If you are new to the world of options contracts, the best parallel example that explains them is insurance.

With insurance, we pay a small premium that we exercise at times of need. Financially speaking, the worst that can happen is for the year to go by and lose the premium without exercising any rights on it.

Irrespective of whether the insurance was needed or not, having it in place makes us owners of the right to claim, and the insurance company is tied by contract to settle.

Options contracts are exactly the same. Instead of claiming insurance money, we claim our right to buy or sell assets.

 

What are options contracts?

Options contracts are legally binding financial agreements, that give investors and traders the right, but not the obligation, to buy or sell an asset at a predetermined price, and before a specified date.

The asset is usually a stock, but it can also be an index, ETF, or other financial product.

 

What does “not the obligation” mean? This is what makes them “options”. Exercising (buying or selling) is at the discretion of the buyer/seller, and at the mercy of the markets.

 

This is distinct from futures contracts that must settle irrespective of profits or losses at expiry. Settlement with options contracts is optional.

 

Important parts and key terms of options contracts:

To fully understand options contracts, we need to know these key terms:

• Strike price
  • The agreed price that allows us to claim our right to buy or sell.
• Premium
  • The upfront cost that buys us the right to claim.
• Expiration date
  • The date options contracts expire, waiving the right to claim.

• In-the-money (ITM)
  • An option already has value if exercised right now. Think of a coupon that saves you money today.
• At-the-money (ATM)
  • The strike price is close to the current stock price. Think of it as a break-even.
• Out-of-the-money (OTM)
  • The option would not make money if exercised right now. Think of the coupon being useless unless prices change.

 

Options contracts: Types

 

Options contracts are commonly traded on exchanges such as the Chicago Board Options Exchange (CBOE), one of the largest options marketplaces in the world. This makes them Exchange Traded Derivatives (ETDs). But options contracts can also be traded outside exchanges, over-the-counter, and facilitated by brokerage houses (OTDs)

 

There are two main types of options. An investor can both buy and sell each type:

• Call options (buy call, sell call)
• Put options (buy put, sell put)

 

Call options: expecting price increases

Call options, give their owner the right to buy a financial instrument, at a predetermined price, before or on the expiration date.

The predetermined price (in options jargon), is called the strike price.

To buy a call option though, someone else has to be willing to sell it. Below we outline two examples of the characteristics of buying as well as selling call options.

 

Buying call options

In our example, we will use stocks but the same principles apply to other asset classes that allow options contracts trading.

Here a stock is trading at $50. Our analysis tells us it will probably rise soon.

We buy a call option with:

• Strike price: $55 (only if it reaches $55 can we exercise the option)
• Expiration: 1 month
• Premium (cost): $2 per share
  • Note: With stocks, options contracts have minimum size 100 shares. So the premium displayed on the platform, is multiplied by 100 to find the full cost.

Potential outcomes:

If the stock touches and rises above the strike price of $55, say to $65, we can exercise our option to buy it at $55. That’s a $10 difference. After subtracting the $2 premium we paid and any other brokerage expenses applicable, our profit would be $8 per share.

If the stock doesn’t rise above the strike price of $55 before the expiry of 1 month, our option will expire worthless, and we lose our $2 per share we paid.

 

From this example: Options contracts Vs owning the shares

If we owned the share, we would be locked in its price tantrums, and lose a lot more than the premium. By locking a small amount (the premium), we take a calculated risk that cushions our decisions irrespective of the outcome.

 

Why buy call options?

• You believe the asset’s price will go up.
• You want to control more shares with less money.
• You want to limit your risk (to the premium paid).

 

Selling (writing) call options

A buyer of a call option needs a counterpart. Someone that owns the assets (not necessarily though, we will explain “naked options” later), and doesn’t think the price will rise much from where it sits.

When selling a call, an agreement binds the seller to sell shares at the strike price, if the buyer decides to exercise the option.

This is also called writing a call.

 

Suppose you already own the 100 shares of the example above. The stock is trading at $50. You sell a call option to the buyer above, with a $55 strike price. You also collect $2 per share.

If the stock stays below $55, the option expires worthless for the buyer. What this means for you? You keep your shares and the $2 premium you collected early in the trade.

If the stock rises above $55, say to $65, you are bound to sell your shares at $55. You don’t pocket the $10 difference because you don’t own them anymore (you kind of pawned them). But you keep the premium.

Note: If you bought these 100 shares lower than $55, you gain from there too.

 

Covered call Vs Naked call

Since you already own the stocks, this is called a covered call. But what if you didn’t own them?

You can still sell a call option, but you are not covered. This is called a naked call.

With naked calls, if the price jumps, you are obliged to buy at the higher price, and immediately sell at the lower price to settle your promise.

Example: Imagine a scenario where you collect a down-payment for a TV you don’t own that is worth $200. Your expected delivery is end of the month. If the price at expiry jumps to $300, since you don’t own the TV, you must buy it for $300 and sell it immediately for $200.

Sounds counter intuitive right? Well, this is the risk of trading naked options.

 

Why sell call options?

• To generate extra income from stocks you already own.
• When you think the stock won’t rise much.
• To slightly reduce risk through premium income.

 

Your upside is limited to the premium. If the stock jumps to $80, you must sell at $55 so capital gains for you (except if you bought lower than the $55)

 

 

Put Options: Expecting price decreases

 

Put options, give their owner the right to sell a financial instrument, at a predetermined price, before or on the expiration date.

The predetermined price is called the strike price.

To buy a put option though, someone else has to be willing to sell it. Like the examples with call options above, below we outline two examples of the characteristics of buying as well as selling put options.

 

Example: Buying put options

Here again a stock is trading at $50. Our analysis tells us it will probably drop soon.

We buy a put option with:

• Strike price: $45 (only if it reaches the strike price can we exercise the option)
• Expiration: 1 month
• Premium (cost): $2 per share

 

Potential outcomes:

If the stock falls to $35, we can still sell it at $45. That’s a $10 difference. After subtracting the $2 premium and any other applicable expenses, our profit would be $8 per share.

If the stock stays above $45 by the expiration of 1 month, the option expires worthless and we lose the $2 premium.

 

Why buy put options?

• You believe the stock will fall.
• You want to profit from a decline.
• You want to protect shares you already own.

 

Selling (writing) put options

A buyer of a put option also needs a counterpart. Someone that doesn’t think the price will decrease.

When we sell a put option, we agree to buy shares at the strike price if the buyer decides to exercise the option.

Example: Selling a put

The stock is trading at $50 like above. We sell a put with a $45 strike and collect $3 per share.

If the stock stays above $45:

• We keep the $3 premium and we do not buy the stock.

If the stock falls to $35:

• We must buy it at $45. We keep the $3 premium, but our shares are worth less than you paid.

 

Here’s another example that doesn’t involve stocks. A house costs $400,000. You tell the seller:

“I’ll promise to buy it for $380,000 if the price drops. Pay me $3,000 for making that promise.”

• If the house never drops like you expected, you keep the $3,000.
• If the house falls to $340,000 because you were wrong. you must buy it at $380,000.

 

Meaning: You get paid for being willing to buy something at a discount. If the value crashes, you’re stuck paying much more than its current worth.

 

Why sell puts?

• You want to buy a stock at a lower price.
• You want to earn premium income.
• You believe the stock will stay above the strike price.
• However, if the stock crashes to $10, you still must buy at $45.

 

 

Why traders choose options contracts?

Traders and investors use options contracts for the same reasons they choose any derivative product.

 

To capitalize on price moves (speculation)

Like in the examples above, options contracts align with specific expectations or personalized analysis.

• Buying calls if expecting growth (and vice versa)
• Buying puts if expecting decline (and vice versa)

 

To reduce exposure and risk (hedge)

Like we saw in our definition above, options can act like insurance.

We pay a smaller premium that allows us to take action when required. Like buying a put to protect stocks we already own in case they fall (either due to volatility, or company announcements, or other).

Even large institutions and funds use options for protection. Major financial indexes like the S&P 500 often have options tied to them, allowing investors to hedge entire portfolios.

 

The premium is a third reason, that futures contracts don’t offer (income)

Investors generate regular income by selling options.

Like with selling covered calls monthly, on long-term holdings. According to popular opinion, selling options contracts has more chances of success than buying them.

 

Are options contracts risky?

Options contracts have a mixed reputation. Some traders see options as risky, complicated and similar to gambling, while others see them as smart risk management tools and income generators on long term holdings.

All traded financial products and instruments pose risk, especially if guesses are uneducated and accidental. Beginner traders especially should not be looking into over complex instruments, until they have a good grasp of the environment, the system that controls them, and doubled down on more straight forward trading applications.

At the same time, all the good reasons for trading options contracts are also valid, and with discipline and time, they can prove very helpful in sizing and protecting portfolios.

 

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