So you’re making a killing on Robinhood. You’ve bought Netflix at a low and sold at a high 50 times over. You’re making good returns, but as the market is seemingly coming out of this you feel the need to hedge some of your bets while also scratching your online trader itch. One way to do this is through the understanding of more complex security transactions, which opens the door to a myriad of differing scenarios all stemming from a basic concept – the “derivative”. A derivative is a financial instrument whose performance is determined by an underlying asset (typically a stock). Think of this as a side bet. As an example, Cade bets Meghan $10 that the Chargers will beat the Washington Football Team (the Underlying Bet). Louis bets Dixon that Cade will not actually pay Meghan if the Chargers lose (The Derivate Bet). As you can see, Louis and Dixon’s bet is tied to the outcome of the bet between Cade and Meghan. Derivates work in a similar fashion. In order to maintain some brevity for this article, we will only focus on the popularized “options” trading as a subset of derivatives. Options are also referred to as a contingent claim contracts and give you the RIGHT, but not the OBLIGATION to execute a future trade at a predetermined price – hence the term “option”.

You Can't Define Me!

Finance revels in creating simple terms that represent complex concepts. To start you on your options journey, we will provide you with some core definitions. Start by skimming through the definition of an option contract, read the rest in detail, and then come back and read the option contract definition again. Trust us, it helps.

Option Contract: A contingent claim in which one party (the buyer) pays a sum of money to another party (the seller), and in exchange receives the right (but not an obligation) to buy or sell the underlying asset at a fixed price, either on a predetermined expiration date, or any time prior. An option has two sides – a “call” and a “put”.
Underlying Asset: In the above example, the underlying asset would be the bet between Cade and Meghan. In your daily use, it would be the stock (ex. Apple, Google, Costco, US Steel, etc.) that you are making a prediction on.
Hedge: Protecting yourself from losses and balancing your investment by playing both sides. Example would be buying Chipotle, but also buying Tums at the same time. If Chipotle does what Chipotle does, you’re still safe because you popped a few godsends in anticipation.
Call: One of the two types of options contracts – provides you the right to BUY the underlying asset at a set price. You buy a call if you believe the underlying is going to increase in price.
Put: The right to SELL the underlying asset at a set price. You buy a Put if you think the price is going to decrease. Think of it as owning a picture with Charlie Sheen’s autograph. If you would have owned that back in 2011 when he was saying all the crazy sh*t about him having Tiger Blood, it was worth a lot! In today’s world, you probably can’t recall the last time you heard his name and therefore his signature is most likely worth less. If you would have bought a Put back in 2015 to sell at the base price back then, it would have hedged against the decrease in price that you see today.
Strike aka Exercise Price: The agreed upon price of the underlying at a time in the future
Option Premium: The price that someone pays to order an option contract. Think of this in terms of a house. You want to buy this house, and the seller wants to sell the house. The buyer is unsure of the quality of the house and doesn’t want to pay the full price right away, while the seller is unsure of the financial standing of the other. To solve this, they require a down payment (option premium) which acts as a hedge if the deal falls through. This allows the party which is putting up the asset to still gain some profit for time and alternative transaction loss.
Long: If you are the buyer of an option, you are considered in a “long-position” and benefit from an increase in value.
Short: If you are the seller of an option, you are considered in a “short-position” and benefit from a decrease in value. The Big Short is a famous Wall-Street movie about the 2008 financial crisis where a small group of professionals profited by betting against the entire world economy…and won!

Rolling 'in the Money'

Referencing some of the above definitions, let’s move into an example. Say Adele creates an option contract with Ed Sheeran. Adele thinks Apple stock is going to go up. Knowing this and the definitions above, she would BUY a CALL. The Apple stock as the underlying asset is worth $10. Adele pays an option premium of $1 to Ed Sheeran, and confirms a strike price of $12 that expires in 30 days. Ed likes this deal because he thinks the price will stay steady, and he will profit from the option premium of $1. Adele likes this deal because she thinks the price will go up to $15 over the next 30 days and she has the OPTION to let this contract expire and not buy the underlying Apple Stock. Let’s explore each scenario:

The market price ends up being $15 at the end of 30 days (or any day beforehand). Seeing as Adele was right, she is “in the money” and would choose to execute on the call option and buy the stock at the predetermined price of $12. She already paid Ed Sheeran $1 as a down payment, so she profits $2 [$15-($12+$1)].
The market price goes down to $8. Adele was wrong! She should stick to singing. Since the price went down, she is “out of the money” and does not want to pay $12 for a stock worth $8 and therefore decides to decline the call option. She losses $1 as she still paid the premium to Ed. Ed is still stuck with a stock that went down, but now has the option premium. Even as he saw the price decline, he could not sell the stock to someone else as he was contractually obligated to sell to Adele. Pull out game weak, Ed.
The market price is the same as the strike price at $12. Adele can do either option, but regardless she will lose the option premium of $1. If she still thinks the stock price will go up, she can buy it and hold the stock. If she thinks it will go down, she does not have to buy the stock. Ed is loving life. He has an extra dollar in his pocket either way. If Adele wants to buy, Ed must sell, but he will still make money as he is selling for market price. Ed (the ‘call seller’ in this case) will always make profit if the option premium is higher than the price volatility of the underlying stock.

A put option would be the opposite scenario. Let’s now say that Adele believes the price of Apple will go down to $8 from where it is now, $10. She wants to sell the stock at the price it is at today instead of selling it at a lower price in the future so she BUYS a PUT at $10 and pays a premium of $1. Ed thinks the price will go up to $15, so he wants to buy it today for less than $15.

As a quick summary, if the price goes down to $8, Adele will execute the put contract and sell the stock at $10 (she will earn $1 profit). If the price does rise to $15, Adele does not have to sell to the buyer and would decline the put option. She would then sell the stock at market price to another buyer and make $4 profit. If the price stays the same, Adele will lose $1 either way.

2 + 2 = 4 - 1 that's 3; Quick Maths

For those that have made it this far, congrats, you are pretty dedicated or perhaps just a fast scroller. Either way - a reason for celebration. Below are some further terms that can help you decide when to execute an option contract or not.

Call Mathematics

Execution Concept – Call Buyer: The profit of Call Buyer (π) is the maximum of either $0, or the Price of Underlying Asset (X) – The Strike Price (S), minus the option premium (P).
- In a formula, it would be written as such π = Max($0,X – S) - P
Execution Concept – Call Seller: The profit of the Call Seller is the negative of the maximum between $0, or the price of the Underlying Asset – the Strike Price, plus the Option Premium.
- In a formula, it would be written as such π = - Max($0,X – S) + P
In the Money (Call): If the market price is greater than the exercise price, the party should execute the call and claim their profit.
Out of the Money (Call): If the market price is less than the exercise price, the party should not execute the call and walk away. They will only lose the option premium.

Put Math

Execution Concept – Put Buyer: The profit of Put Buyer (π) is the maximum of either $0, or the The Strike Price (S) – Price of Underlying Asset (X), minus the option premium (P).
- In a formula, it is the similar to the call seller except that the strike price and market price are flipped: π = Max($0, S - X) - P
Execution Concept – Put Seller: The profit of the Put Seller is the negative of the maximum between $0, or the price of the The Strike Price - Underlying Asset, plus the Option Premium.
- In a formula, it is the similar to the call seller except for the strike price being greater than the exercise price: π = - Max($0, S - X) + P
In the Money (Put): If the market price is less than the exercise price, the party should execute the call and claim their profit.
Out of the Money (Put): If the market price is greater than the exercise price, the party should not execute the call and walk away. They will only lose the option premium.

Catch Me If You Can

None of the information on this website should be viewed as financial advice or recommendations. If you are lacking confidence in your investing capabilities, I suggest you speak with your wealth manager to help you determine what your investment goals may be and how to reach them.

So Many Options – Advanced Stock Trading for Beginners