Here’s a little story to help you understand options!
Let’s imagine you’ve saved enough money to purchase this beautiful house pictured above. You don’t want to buy the house yet since you want to look for other houses that might be better, but you also don’t want someone else to buy the house while you are looking around. You are also worried that an upcoming storm will damage the house, and don’t want to buy the house before the storm.
Well, what can you do?
You can make a contract with the person selling the house by paying them some money upfront (a premium), in return for the right to buy the house within a certain time period. You do not get your premium money back. Note that you are also not forced to buy the house.
This contract you made with the owner is a win-win situation for both parties! Perfect! The owner of the home is happy since they get to keep the premium, and you are happy since you can buy the home within a certain time period without worrying about someone else buying the house or the house getting destroyed.
Quick Check: Will the premium be more or less expensive if the contract ends/expires in 2 weeks instead of 1 week?
Now, let’s tie in the house example to options.
With options, the buyer of the contract has the right, but not the obligation (in other words, the buyer can, but isn’t forced), to either buy or sell a stock at a specific price. This specific price is known as the “strike price.”
There are two types of options, a “call” and a “put.” The call option gives you the right to buy stock at the strike price, and the put option gives you the right to sell stock at the strike price.
One more important piece of information that you need to know is that one option contract has control over 100 shares of a stock.
Great, so here’s an example. Below is the “option chain” for Apple (AAPL).
The strike prices are displayed on the far left. The expiration date for the contract is April 13th, 2018, and the most recent price of the option contract is under the “last trade” tab.
Let’s say you purchase the April 13, 2018, 180 strike price call for AAPL since you think the price will go up within the next 31 days.
Remember, the call option gives you the right to buy AAPL at $180 regardless of where the price of the stock is within the next month. For example, if AAPL closes at $250 (the option is said to be “in the money” if the market price is above the strike price) on April 13, 2018, you can exercise (use) your option contract and buy 100 shares of AAPL at $180. If the option contract expires in the money, your broker will automatically buy (exercise the contract) 100 shares of AAPL from the seller of the contract and deposit the 100 shares of AAPL into your account.
As of March 14, 2018, AAPL is currently trading at $178.6. The contract will cost you “3.63” as you can see in the “last trade” tab. The 3.63 refers to the price of one share and since the option contract has power over 100 shares, you would pay an upfront premium of $363.
Let’s say at market close (4:00 PM Eastern Time) on April 13, 2018, AAPL is at $178. Your call option contract allows you to buy shares at $180. Would you do it? Of course not! You simply let the option “expire” worthless and you don’t have to do anything else.
Remember that Put options are the same thing as Call options except that they give you the right to sell 100 shares of a stock at the strike price. You would buy a put option if you thought the price of the stock was going to fall.
If you change your mind during the month and don’t want your call option contract anymore, you can simply sell it back to the market at the current bid price.
Answer to the quick check question is as follows: The longer option contract costs more because the stock price has more chances to fluctuate before it expires. If you think about the example with the house, the owner selling the home would charge you more if you requested to hold the house for a longer time.
- Options give you the right, but not the obligation to buy or sell shares of stock at a certain price (strike price)
- Each option contract has control over 100 shares of stock
- You pay a premium to the option seller, who collects your premium as cash upfront
- A “Call” option gives you the right to buy at the strike price before the contract expires. You would buy a call if you think the price will go up.
- A “Put” option gives you the right to sell at the strike price before the contract expires. You would buy a put if you think the price will go down.
With American Options (Options traded in the United States), you are allowed to exercise your option before the expiration date, meaning you can buy 100 shares at the strike price before the contract expires. European Options do not allow you to exercise the option before the expiration date.
Options decay to about a 1/3 of its’ value after half of its’ life assuming it’s IV (implied volatility) doesn’t change. The other 2/3 of its value decays in the last half of its’ life. It makes sense that the value of the option decreases faster when it gets closer to expiring since the stock price won’t have as much time to fluctuate. In sum, the time decay affecting the price of the option is not linear.