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Options Knowledge Center

Options Knowledge Center

An option is a contract between a buyer and a seller. These contracts are part of a larger group of financial instruments called derivatives. This means that the instrument is derived from another security–in our case, another stock.

Options Versus Stocks

Options are a way to actively interact with stocks you’re interested in without actually trading the stocks themselves. When you trade options, you can control shares of stock without ever having to own them.

Call Options

Owners of call options expect the stock to increase in value, while sellers of call options expect the stock’s value to decrease or remain the same.

Buying a call option gives you the right, but not the obligation, to buy 100 shares of the underlying stock at the designated strike price. The value of a call option appreciates as the value of the underlying stock increases.

Selling a call option allows you to collect the premium while obligating you to sell 100 shares of the underlying stock to the owner at the agreed-upon strike price.

Example

What if you think the price of the stock is going up?

In this case you'd buy to open a call position. Buying a call gives you the right to purchase the underlying stocks from the option seller for the agreed-upon strike price. From there, you can sell the stocks back into the market at their current market value if you so choose.

For example, you think MEOW's upcoming product release is going to send the price of the stock soaring, so you buy a call for MEOW at a $10 strike price with a $1 premium (the cost of the contract) expiring in a month. 

Let's break that down.

Symbol: MEOW

Expiration: A month from now

Strike Price: $10

Premium: $1 

The product release gave the stock a bump, and the day your contract expires, MEOW hits $15. Great! This means you can sell the contract in the market for at least $5 and earn at least a $4 profit per share. 

The reason the contract is worth at least $5 is that you could exercise the contract to buy the shares at $10, then sell the stocks in the market at their current trading price of $15. You'd earn $4 per share if you exercised the contract instead of selling it.

Put Options

Owners of put options expect the stock to decrease in value, while sellers of put options expect the stock’s value to increase or remain the same.

Buying a put option gives you the right, but not the obligation, to sell 100 shares of the underlying stock at the designated strike price. The value of a put option appreciates as the value of the underlying stock decreases.

Selling a put option allows you to collect the premium, while obligating you to purchase 100 shares of the underlying stock from the owner at the agreed-upon strike price.

Example

What if you think the price of the stock is going down?

In this case, you could buy to open a put option. Buying a put gives you the right to sell the underlying stock back to the option seller for the agreed-upon strike price if you so choose. 

For example, you think MEOW’s upcoming earnings call is going to tank the price of the stock, so you buy 1 MEOW put option expiring in a week with a strike price of $10 for a premium (the cost of the contract) of $2.

Let’s break that down.

Symbol: MEOW

Expiration: A week from now

Strike Price: $10

Premium: $2

Your prediction is right, and within the week MEOW is trading at $6. Your put option is now worth at least $4, so you can sell it in the market for a profit (less the cost of your $2 premium). You’ve just made $200 on MEOW’s decrease in value.

The Strike Price

The strike price of an options contract is the price at which the options contract can be exercised.

Think of the strike price as the anchor of your contract: If you’re buying a call, your call is profitable if the value of the stock goes above the strike price (plus whatever premium you paid). If the value of the stock stays below your strike price, your options contract will expire worthless. Remember, you’re not actually buying shares of the stock unless you exercise your contract. This is because the contract gives you the option to buy the actual shares of the stock at the strike price.

The Ask Price

The ask price is the amount of money sellers in the market are willing to receive for an options contract. The ask price will always be higher than the bid price.

The Bid Price

The bid price is the amount of money buyers in the market are willing to pay for an options contract. The bid price will always be lower than the ask price.

Buying and Selling an Options Contract

Options can be tricky, so it’s important to know exactly how the actions you take will get you closer to your goal:

  • Buying to open an options position means that you’re purchasing the contract. You’re the owner, and have the right to place an order to sell the contract back into the market, to exercise the contract, or to let it expire.
  • Selling to close a position means that you’re selling a contract that you own back into the market.
  • Selling to open an options contract means that you’re selling the contract to a buyer to collect a premium. You have the obligation to make good on the contract if you’re assigned, or you could buy it back in the market.
  • Buying to close an options position means that you’re buying back a contract that you sold. In this case, you cannot be assigned on the contract you initially sold.
Exercise and Assignment

The owner of an options contract has the right to exercise the contract, let it expire worthless, or sell it back into the market before expiration. The owner of the contract is likely to exercise the contract if it’s “in the money.” On the other hand, the person who sold the contract to collect the premium is assigned when the owner of the contract exercises it.

For more information on exercise and assignment, check out our article Exercise, Assignment, & Expiration.

Knowing When to Buy or Sell

When opening a position, you can either buy a contract with the intention of exercising it when it reaches its strike price, or you can sell a contract to collect the premium and hope to not be assigned. Buying an options contract makes you the owner/holder of the contract, and in return for paying the premium, you have the right to choose to either exercise the contract, let it expire worthless, or sell it back into the market before expiration. The seller of an options contract collects the premium paid by the buyer, but is obligated to buy or sell the agreed-upon shares of the underlying stock if the owner of the contract chooses to exercise the contract.

options_chart.png

  • Buying to open a call: You expect the value of the stock to rise; you pay the premium; you have the right to buy 100 shares at the strike price if you exercise.
  • Selling to open a call: You expect the value of the stock to drop or stay the same; you collect the premium; you have the obligation to sell 100 shares at the strike price if you’re assigned.
  • Buying to open a put: You expect the value of the stock to drop; you pay the premium; you have the right to sell 100 shares at the strike price if you exercise.
  • Selling to open a put: You expect the value of the stock to rise or stay the same; you collect the premium; you have the obligation to buy 100 shares at the strike price if you’re assigned.
The Premium

Since the owner has the right to either exercise the contract or let it simply expire worthless, she pays the premium–the per-share cost for holding the contract–to the seller. As a buyer, you can think of the premium as the price to purchase the option. If you buy or sell an option before expiration, the premium is the price it trades for. You can trade the option in the market the same way you’d trade a stock. The premium is not arbitrary, as it’s tied to the value of the contract and the underlying security: the underlying stock’s price, the underlying stock’s volatility, and the amount of time left until expiration all influence an option’s premium.

Rights and Obligations

The owner has the right to exercise the contract or not, whereas the seller has the obligation to make good on the contract if she’s assigned. When the owner of the contract exercises it, the seller is assigned.

Time Value

The closer an option is to expiring, the less time value the option will have. The further away a contract is from its expiration date, the more potential there is for price movement, which would make the contract trade at a higher price.

The Break-Even Point

The break-even point of an options contract is the point at which the contract would be cost-neutral if the owner were to exercise it. It’s important to consider the premium paid for the contract in addition to the strike price when calculating the break-even point.

Contracts

It’s important to also keep in mind that contracts are typically for 100-share blocks. In the above example, you’d be entitled to buy 100 shares of MEOW at the agreed-upon strike price. Most contracts on Robinhood are for 100 shares.

Though options contracts typically represent 100 shares, the price of the option is shown on a per-share basis, which is the industry standard.

Reference No. 20190919-956057-2886519
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