Become a better investor
Lesson in Course: Derivatives and options (beginner, 4min )
I can start to see how options are very different than stock. What is in an option that makes them so different?
Options can seem intimidating as we're starting out. They tend to have a lot more moving parts than stocks, and we may have heard about the negative consequences of misusing options. We're going to simplify things by imagining one of our friends had just asked us if we'd like to go to a concert with them for their birthday. Some immediate questions that come to mind before we say yes are, "What is the band? When is it? and How much does it cost?" Let's answer those questions for an option.
The takeaways for this lesson are:
The underlying of an option is the asset promised in a contract between two investors.
In most cases, the buyer and seller of an option contract are making an agreement on the future purchase or sale of a stock of a public company. However, the investors aren't just limited to stocks and can make the underlying any other vehicle with a ticker. This can include ETFs, Mutual Funds, and REITs. The options contract between the investors represents an agreement to either buy or sell this underlying asset, and the value of the options contract depends on the price of the underlying.
Typically, a single option contract represents the right to purchase 100 shares of the underlying.
A lot size of 100 shares is standard across all options contracts. The lot size brings a larger component of risk to stock options since one stock option exposes us to the price movement of 100 shares. Both gains and losses are magnified.
The maturity of an option is the last trading date the contractual agreement is good for.
The option contract is in effect from the minute we purchase it until the end of the maturity date stated on the contract. After the maturity date, the option contract is expired or void. As a buyer, we can only pick from the available maturity dates presented by sellers. Once the maturity date is determined, it cannot be changed.
The strike price is the price of the underlying stock that the buyer and seller of the option contract have agreed upon to cover in the contract.
We learned above that an option contract is between two investors to buy or sell the underlying. The contract also states the price the underlying can be bought or sold. For example, the strike price for a call option is the price per share the option holder can buy stock from the seller of the option. The strike price for a put option is the price per share the option holder can sell stock to the seller of the option.
The option price is how much the buyer has to pay the seller to own the contract based on the maturity date and strike price.
Not to be confused with the strike price, the option price represents the cost the seller is charging to buy the options contract. The option price can also represent the cash we would receive if we became sellers of the options contract. It's important to note that the option price is quoted on the price per share for the contract and we need to multiply by the share count covered by the contract(s) to arrive at the total cost.
For example, the option price for a $9 strike price call option on Ford stock($F) is $2 per share. The cost to buy one contract requires us to multiple the price by the lot size ($2.00 x 100) for a total cost of $200. Two contracts would cost us $400 ($2.00 x 100 x 2), and so on.
Here is an example of where to find most of these components within the user interface of a mobile trading platform like Robinhood.
No matter what type of options, every contract will have a unique combination of these five components. We should get familiar and comfortable with these components as they will build directly into basic and advanced strategies. Do we feel confident enough to explain these concepts to a friend? Invite them today to learn along aside you.