Understanding Stock Options
In the simplest of terms, stock options are merely another financial instrument like stocks or bonds. There is no need to be intimidated! If you’ve done any research about options on Google, you’ve probably come across this phrase before: “options give you the RIGHT, but not the obligation, to buy a security at specific price within a specific time period.”
Now, if you’re like the rest of us, that’s an easy phrase to go in one ear and out the other.
What are Stock Options?
Chances are, if you know someone who worked at a startup company, you’ve probably already heard the phrase “stock options.” A lot of the time (or perhaps never), you will hear the phrase, “he had stock options at XYZ company when it was just beginning – and now he’s retired.” When someone says this, and uses the phrase “stock options,” although they are technically being correct, it’s strange terminology to use in the options trading world.
This is because, for the most part, when most people are talking about options, they are referring to stocks (a.k.a. equities). But, to be fair, there are other types of options, like futures options and currency options. Both of these two forms of options function the exact same way, but the most common type of options are traded on stocks and stock indices.
Binary options, however, are completely different than options that are traded in the US. In fact, it’s difficult to include binary options in this article, because they are far more analogous to gambling and betting than they are to investing and trading. Nevertheless, binary options are indeed a type of options and they are important to know about, but they should be traded at your own risk.
How Options Work
Options are always derived from an underlying asset (the stock, futures contract, etc.); this is why options are in a financial asset group known as “derivatives.”
If a trader were to purchase a call option, he would be making an assumption that the price of the underlying instrument is going to increase in value.
Conversely, if he were to purchase a put option, he would be making an assumption that the price of the underlying instrument is going to decrease in value.
Let’s do an example to get a better understanding.
Suppose AAPL stock is trading at an $144 a share.
An options chain, showing both puts and calls, would look something like this:
As with almost all brokers, calls are on the left and puts are on the right of an options chain – always. That’s just the way it is.
As you can see from the options chain, the $160 strike calls (left side) are trading a midprice of .30 and the $125 strike puts (right side) are trading with a midprice of .31
This means for $30, you can buy 1 contract that will guarantee you the right to buy AAPL stock at $160, even though $AAPL is currently trading at $144. If AAPL goes up, so will the value of this option.
On the put side, you can buy 1 contract for $31 that will guarantee you the right to sell AAPL stock at $125. If AAPL goes down, this put will go up in value.
Similarities Between Options and Stocks
There is a “bid” and an “ask” just like with stocks that create the market for the options. Options that are further out-of-the-money are going to be cheaper than options that are near-the-money or at-the-money and vice versa.
When an option is at-the-money, it just means it is trading exactly where the price of the stock is trading. In the AAPL example, the at-the-money options would be the $145 calls and the $140 puts.
The in-the-money call options are all of the options from “0” to the current price of the stock. And the at-the-money put options are from “infinity” to “0”. However, because there is a reasonable expectation that AAPL will not be trading up 5000% tomorrow, the out-of-the-money call options and in-the-money put options don’t go to infinity.
This is because the expected distance that a stock will trade in a given time is derived from the prices of it’s options. So, what determines the prices of options?
Well, this is a multi-billion dollar question that gigantic firms like Citadel and Virtu Financial have hired teams of data scientists in an attempt to answer.
For now, know that the main options pricing models (like the Black-Scholes model) work off of these elements: strike price of the option, current price of the underlying stock, time to expiration, dividend yield of the stock (if any), interest rates, and implied volatility.