E-Trade Options Table
  • Facebook Social Icon
  • Twitter Social Icon
  • Google+ Social Icon
  • Pinterest Social Icon
  • Instagram Social Icon

What are Options?

An option is a financial derivative that represents a contract between the buyer (option holder) and the seller (option writer). The option contract offers the buyer the right, but not the obligation, to buy or sell a security or other financial asset at an agreed-upon price. One option contract represents 100 shares of stock

Options have several different uses. Options can be used to speculate which can be very risky. Options can also be used to hedge positions and reduce risk. Investors can also use options as a tool to generate investment income.

There are two types of options, a "call" option and a "put" option. An investor or trader can go long (or buy) a call or a put. And they can also go short (sell) a call or a put. Whether an investor buys or sells a call or a put depends on the investors motives and expectation of the underlying investment instrument. We will provide an example below using a hypothetical company Pear Tech, (PEAR) as our underlying investment instrument. You may be familiar with Pear Tech from our "What is a Stock?" explanation.

Stock: Pear Tech (PEAR)

Current Price: $100

Date: January 5, 2018

Scenario: An investor believes Pear's stock will increase to $150 by January of 2019.

1. The investor can buy a call option.

2. The investor can sell a put option.

In this scenario buying a call option or selling a put option will benefit the investor if Pear's stock rises.

Stock: Pear Tech (PEAR)

Current Price: $100

Date: January 5, 2018

Scenario: An investor believes Pear's stock will decrease in price to $70 by January of 2019.

1. The investor can sell a call option.

2. The investor can buy a put option.

In this scenario selling a call option or buying a put option will benefit the investor if Pear's stock declines.

Understanding an Option Contract

PEAR Jan 18 2019 $100 Call

Above is an option for Pear Tech. Lets break down the option to get a better understanding of what it all means.

PEAR This is the ticker symbol for Pear Tech. The name of the underlying stock's ticker symbol will appear at the beginning of the option's quote.

Jan 18 2019: This is the expiration date of this particular option. An investor who purchases or sells this option must buy, sell, or exercise the option before January 18, 2019. After that date the option is worthless.

$100: This is the strike price. If an investor has purchased a call option, and the stock price is above $100 or above the strike price the investor will be in the money, if the stock price is below the strike price the investor will be out of the money. (commission not taken into consideration)

Call: This tells the investor if the option is a call or a put.

Each option contract represents 100 shares of stock. We will talk about how this applies when exercising the option below. Like stocks, options have a bid and ask price. At the time of this writing the PEAR Jan 18 2019 $100 Call is $15.25 / $15.75 (bid price / ask price). The price of an option is called a premium.

How An Investor Makes Money With Options.

Making Money Part 1.

Using our example above that an investor believes Pear's stock will increase to $150 per share before January 2019. The investor purchases the Pear call option contract for a premium of $15.75 in January of 2018. Let's say that in September of 2018 Pear's stock is now selling at $155 per share. The investor who purchased the Pear option can "call" the stock away from the option seller. The seller of the option must sell 100 shares of Pear's stock to the option buyer for $100. The investor (option buyer) now owns Pear at $155 per share, but only paid $100 per share. The investor made $55 in profit per share. In this example the investor or options purchaser would only "call" or "exercise" the option if the stock price is above the strike price. If Pear's stock were trading at $90 per share, there would be no need to "call" the stock or "exercise" the option. The investor could just purchase the stock for $90 in the market. 

So in this example, when Pear's stock price was over $100 per share, the investor who purchased the option had the right, but not the obligation to call the stock away at $100.

Making Money Part 2.

Staying with our example above, when the investor purchased the option, Pear's stock was trading at $100 per share, and the investor paid a $15.75 premium for the call option contract. As the underlying stock increases so does the premium of the option. In our example Pear's stock was trading at $155 per share in September 2018, the option that the investor purchased is now trading at $26.75. The investor can sell the option in the market for a premium of $26.75 and collect the $11.00 profit.

 

Why Would The Investor Sell The Option Instead of Calling The Stock?

If you remember from above one option contract represents 100 shares of the underlying stock. In our example the option has a $100 strike price and Pear is currently trading at $155 per share. To "exercise" the option or "call" the stock away from the option seller, the investor will require a cash outlay of $10,000 (100 shares x $100 per share). Once the investor purchases the 100 shares of Pear, she can sell it in the market for $155 per share, making $5,500 in profit (commissions not included). But what if the investor doesn't have $10,000 to "call" the stock away? In this case the investor can sell the option for the $26.75 premium. The investor would receive $2,675 for selling the option and closing their position ($26.75 x 100), and would make a profit of $1,100, ($26.75 - $15.75 = $11.00 x 100).

Summary

What we covered is the basics of the basics when it comes to options. Options can be extremely risky. One of the risk with options is that upon expiration, if the option holder doesn't buy, sell, or exercise the option they can lose their entire investment. Using our example, if on January 18, 2019 Pear is trading at $100 and the option holder didn't sell the contract or exercise the option, the contract will expire worthless and the investor will lose their entire investment or $15.75.

This is a good start for a beginner who is curious about what options are. Options can be extremely complicated, and we plan to discuss options in more detail in the future.. 

Keep an eye out for more articles coming to our Beginners Block. Get notified about our new articles by leaving us your email.