Options Basics

Options Trading Guide for Beginners

Options Overview

Options contracts (also called ‘options’ or ‘contracts’) give investors a choice to buy or sell a specific stock at a guaranteed price in the future. Each contract grants its owner the right to trade 100 shares of an underlying stock at the strike price before its expiration.

By the end of this section, you should be able to:

Identify the buyer and seller of an options trade
Understand the benefits/costs of either buying or selling contracts
Distinguish between call and put options
Understand the rationale behind these two option types

Buying Options

The option holder buys an option contract by paying a premium to the option writer. The option grants the buyer a right to exercise it, which would force the seller to trade 100 stock shares at the strike price.

However, options are only eligible for exercise if the option’s strike price is better than the underlying stock’s share price. Depending on the contract type (buy or sell), it would be better to buy at a lower price and sell at a higher price.

Therefore, options allow us to buy or sell stocks at the strike price OR share price, whichever is better. If it’s more cost-efficient to trade at the strike price, we would rather exercise the option. Otherwise, we could buy or sell shares directly on the stock market.

Buying an option doesn’t always mean we want to trade the underlying. We can also sell the option for a higher premium than we paid to buy it.
Limitless Tip

Selling Options

The option writer sells an option contract by collecting a premium from the option holder. The seller is collecting payment in exchange for taking on the risk of assignment, which creates an obligation to fulfill an exercised option.

Once the option holder exercises and upon receiving the assignment, the option writer MUST make the underlying trade. Depending on the contract type (buy or sell), the seller must supply the underlying shares or cash to fulfill the option.

Since option exercise enables the buyer to trade at favorable prices, the assignment to fulfill that trade would be unfavorable for the seller. The seller will have to buy stocks for more and sell stocks at a lower price. Ideally, the option would expire worthless so that we can keep the entire premium as profit.

Some strategies rely on selling options to receive assignment at a desirable strike price. These options enable us to continuously collect premiums until we ultimately trade the shares at the desired price.
Limitless tip

Call Options

Call options give us the right to buy 100 shares when the underlying share price is higher than the option’s strike price.

When shares are trading above the call’s strike price, we can exercise to buy them at the lower strike. If the shares are trading below the strike, we get a better deal by directly buying the shares. Therefore, owning a call allows us to choose between buying at the strike price or share price, whichever is lower.

Call Options Analogy

Call options allow us to secure the lowest available purchase price for an asset.

Suppose we want to buy a house in anticipation that real estate prices will rise. On the one hand, there’s no guarantee that prices will appreciate if we buy at today’s low prices. But if we wait too long, we might end up paying more and lose out on profits.

Luckily, we manage to buy a call option from a homeowner who wants to sell their $200,00 property. For paying a $5,000 premium to lock in today’s price, we have a right to buy the house at the $200,000 strike price before a one-year expiration.

If house prices go up, we can exercise the contract ($5,000 value) and buy the house ($200,000 value) for a net cost of $205,000. We assign the homeowner a legal obligation to sell us the home for less than its worth.

Limitless Tip: A fixed amount of money is generally worth more today than in one year. Since the option writer is holding onto the asset at a fixed price, they lose the opportunity to sell immediately and reinvest for more profits. The premium also accounts for this ‘opportunity cost.’

If the property value never exceeds $200,000, we would be able to buy the house at market value for less. Since we wouldn’t have to exercise the option to buy it, the option expires worthless.

Put Options

Meanwhile, put options give us the right to sell 100 shares when the underlying share price is lower than the put’s strike price.

When shares are trading below the put’s strike price, we can exercise and sell them at the higher strike. If the shares are trading above the strike, we get a better deal by directly selling the shares. Therefore, owning a put allows us to choose between selling at the strike price or share price, whichever is higher.

Put Options Analogy

Put options allow us to secure the highest available sale price for an asset.

Suppose we bought the house in our previous analogy for $200,000. We could sell the house at its current value of $250,000, but the housing prices still have room to rise. However, we may lose money if we wait too long, and the house drops below our purchase price of $200,000.

This time, we buy a put option for a $6,000 premium. The option gives us the right to sell the house at $250,000 with a one-year expiration.

If the house value falls below the $250,000 strike, we can exercise the option and sell the house at that price. The homeowner must buy at $250,000, netting us $244,000 after accounting for the premium we paid.

If the property value never dips below $250,000, we could sell the house at its higher market value. Since we never exercise the option, it expires worthless.

Option Types

There’s a simple way to remember which direction the stock price should move to create a more favorable trade:

You would CALL UP your friend to GET them on the phone.
When the stock price goes UP, your CALL allows you to GET (BUY) shares at the lower strike price.
You would PUT DOWN the phone if you want to LEAVE the call.
When the stock price goes DOWN, your PUT allows you to LEAVE (SELL) your shares at the higher strike price.

We should also note that it’s only possible to exercise a call when the underlying moves above the strike price. Meanwhile, we can only exercise a put when the underlying moves below the strike price.

Options Summary

Options guarantee a stock trade at a later date.
Option holders have the right to exercise options and force the trade
Option writers who receive assignment must fulfill the exercised option
You can buy discounted stocks when share price exceeds a call option’s strike.
You can sell stocks for more when the share price drops below a put option’s strike.

Option Terminology

Option – a contract guaranteeing a future price on a specified stock
Underlying stock – the stock guaranteed by the option
Strike Price – the guaranteed trade price of the underlying stock
Option Holder – the option buyer/owner
Option Writer – the option seller
Exercise – the buyer’s choice to trade the underlying stock at the strike price
Assignment – the seller’s obligation to fulfill the underlying trade
Expiry – last date to exercise the option
Premium – the cost to obtain an options contract