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Buying an option

Lesson in Course: Derivatives and options (beginner, 6min )

I am finding options less intimidating. What are the first steps I should take before ever buying options?

The simplest way to use options is to buy an option contract that covers a specific stock, ETF or mutual fund. When buying an option contract, we are offered two choices, and depending on the choice we can expect very different results. 

KEY TAKEAWAYS:

The three takeaways for this lesson are:

  • Learn about put and call options
  • Understand when to buy each 
  • Be able to find an option on an option chain

Deciding on a direction

The first step is to come up with an informed opinion on the direction of the future stock price. 

buying a call

We purchase call options when we think the underlying stock will go up in value.

As a refresher, a call option is a contract between the two parties that allows the owner of the contract to buy stock from the seller of the contract. Call options serve as a good one-way bet on an increase in the stock price.

buying a put

We purchase put options when we think the underlying stock will down in value

A put option is a contract that allows the owner of the put option to sell stock to the seller of the contract.  Put options are a little more versatile and can be used as more than one-way bets on the decrease in stock price. We'll cover those use cases in future lessons but for now, let's dive into a short video by InTheMoney and learn more about the basics of call and put options.

Reading the menu

Next, we will need to take a look at the available options for purchase and decide if there's an appropriate one we'd like. The list of available options for purchase is presented differently than stocks in the form of an option chain

the Option chain

Option chains are tables of put and call options for purchase organized by different strike prices and grouped by maturity date available.

Below is an example of an option chain for XYZ stock with a maturity date of January 15, 2021. The Bid and Ask represent the prices buyers and sellers are quoting. For the time being, we can ignore these prices now and just pay attention to the last price.

Robinhood option chain

An option chain will always have the range of strike prices listed in the middle column. Available call and put options are on the left and right side of the strike price respectively. Each row contains the current market prices for the options contract for that strike price. Color shading is often applied to distinguish in-the-money options from out-of-the-money options—a topic we will cover in a later lesson. 

Can we spot these contracts?

  1. $2.96 in premiums per share for January 15, 2021, $130 strike XYZ call options
  2.  $9.15 for January 15, 2021, $130 strike XYZ put options

Option chains can look different depending on the platform. Below is a simplified user interface of an option chain on Robinhood. Outside of bids and asks, we should be able to locate the same information as above.

A big, little primer on options - Robinhood
 

While options were originally created for individual stock, today we can actually buy call options on any underlying. This includes individual stocks, ETFs, REITs, and other levered products. The only securities we can't buy options on are other options (unless those other options are already bundled into an ETF).

We've only just covered the first two steps every investor needs to take before actually buying an options contract. Being able to read an option chain allows us to understand the available options for purchase. As we continue to learn more about how the strike price, underlying stock price, and other factors impact the value of stock options, we'll be able to start picking specific options appropriate for us within the chain.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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