Investment: Understanding the Basics of Options (Part 1)

A summary for the CFP exam

Option trading is among the more confusing topics of investment. I will write a few posts on this topic and focus on the elements that are heavily tested.

What are Options?

Options are contracts involving two parties.

The owners (buyers) of options are entitled to purchase or sell a specific asset for a particular price within a specified time period (American options) or at a specified future date (European options).

Each option contract has a buyer and a seller. The seller/writer of the option contract is obligated to sell or buy a specific asset for a specific price within a specified time period (American options) or at a specified future date (European options).

The specific price stated in the option contract is referred to as strike price or exercise price.

Assets can be in forms ranging from stock, real estate to merchandise. Options are derivatives in the sense that the value of options is derived from an underlying asset.

Wow, the whole thing reads like a tongue twister. What? You can buy or sell the right to sell or buy?

Let’s use stock options for the rest of the post. Other types of options follow the same logic. A stock option contract represents 100 shares of the underlying stock.

Call Options

Loosely speaking, a call option is the right to buy a specified number of shares at the strike price in the future (before the contract expires).

Buyers pay a premium to own a call option. You can think of this premium as a deposit. Before (or at) the contract expires, the buyer of the call option has the right (or the option/choice) to purchase the underlying stock at the strike price.

Why would someone pay premiums to purchase a call option? Why won’t everyone just purchase the underlying stocks directly?

One reason is speculation. No one knows if the stock will go up for sure. It’s all about odds. If Mike believes that the price of Zoom stock will go up from the current price of $300 per share, Mike can purchase a call option. Let’s say the stock price rises (higher than the strike price) as expected; Mike has the right to purchase a specified number of shares at the strike price. Mike does not have to make the purchase, however. The seller party of this call option contract gets to keep the premium either way but is obliged to sell the shares at the strike price to Mike if Mike chooses to exercise his option.

If Mike were wrong about his speculation and Zoom stock price dropped, Mike would not exercise his rights to purchase at the strike price. Thus Mike did not suffer much from the drop in stock price. In a way, buying a call option can be less risky than buying the underlying stock. The decline in stock price can include a wide range depending on the stock price, while the premium to purchase the call option is fixed. Buying a call option lowers the risk of market downside but also cuts into the gains of upside.

Okay, now we see the benefits of purchasing a call option. Who would sell a call option then? The party with the opposite prediction. Following our previous example, the seller (let’s call her Selina) of the call options believe that the price of the underlying stock will not increase during the specified time. As long as the stock price stays the same or goes down, the buyer of the call options will not exercise the options, which means that Selina gets to keep the premiums. Selling call options is also referred to as writing call options. Similarly, sellers of the options are referred to as writers.

If the stock price climbed up (not something that the seller of a call option wished for), the stocks would most likely be called away by the call option buyer (remember Mike?). Being called away means that Selina needs to sell the pre-arranged shares to Mike at the strike price (lower than the current stock price). Writing covered calls is an income-producing strategy. Stock owners may have enjoyed the appreciation of the stock for a while but do not want to sell immediately yet. Selling call options generate premiums without selling the stocks if the price goes down (or stay the same). Suppose shares being called away, not the worst thing on earth.

How does Selina come up with the shares if being called away? There are two possibilities. The first one is that Selina actually owns the shares, and she just needs to “give” them to Mike. This situation is referred to as a “covered call.” Another possibility is that Selina does not own any Zoom stocks at all. When Mike exercised his right to buy, Selina had to purchase the shares at the current price, regardless of how high they had become. This is called “naked calls.”

Writing naked calls is one the most dangerous adventure since there is no upper bound on stock prices. Most people fear the market downside, but the farthest stock price can drop to is 0. For example, the most you can lose from the current $300 share price is $300 a share. It’s a lot, but it is bounded. For Selina, the danger of writing a naked call lies in the possibility of the stock rises to $2000 a share. Selina would have to buy at $2000 per share in the market and sell to Mike at the strike price (maybe $310 per share).

In the next post, we will talk about put options.