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How Options Work - The Basics

Posted on January 27, 2009 by Adam

If you have never traded options before then there is a lot to learn. Options were traditionally used by institutional investors to hedge their positions, but the proliferation of online discount options brokers has caused options trading to become much more widespread among retail investors.

Options can still be used to hedge, but they can be a lot more fun too. I am a directional options buyer, which means that I buy options, speculating on the direction of price movement. There are numerous spread trading strategies, where traders buy and sell various combinations of options contracts to achieve a desired risk profile and return.

I wrote an article recently about the basics of options theory. You can read that here.

So what is an option? An option is a contract between the buyer of the option and the seller (writer) of the option. Options are derivatives, since they derive their value from an underlying asset. That underlying asset may be stocks or futures.

There are two kinds of option contracts: calls and puts.

When you buy a call option contract you are buying the right, but not obligation, to purchase 100 shares of the underlying stock at the given strike price from the option seller. The catch is that the option will expire at a certain date and if you want to exercise it you must do it on or before that date.

For example, if I buy a February 85 call for AAPL, I have the right to buy 100 shares of AAPL at $85 per share on or before the third Friday in February. 85 is the strike price in this case. Notice that I do not have to exercise the option if I do not want to. That’s why it’s called an option.

Puts are the same, but they give you the right to sell the underlying instrument.

If I were to buy a February 85 put for AAPL, I have the right to sell 100 shares of AAPL at $85 per share before the third Friday in February to the seller of the option. If I have the shares already I would be selling those - if I didn’t, then I would be short 100 shares after the exercise.

I hardly ever exercise the options. I normally just buy them and sell them.

As of today’s close AAPL is trading at 89.64. So why would I want to buy an 85 put? If I wanted to sell AAPL I could get a better price by selling on the stock market. That option has essentially no value - we would say it is out of the money. An 85 call, on the other hand, gives me a $4.64 discount. The 85 call is in the money.

So how much do the options cost? Like anything worth having in life, they aren’t free.

Well, how much would you pay for a February 85 call on AAPL? Would you pay $4.64 per share? Probably. But I would pay more. So would other options traders. Why would that be?

February 85 calls are currently trading for $7. $4.70 of that money is the discount we get. The rest of the option premium, $2.30, is the value that speculators see in the contract. In other words, traders are speculating that AAPL will move far enough before expiration to cover that extra $2.30 in cost.

The part of the option premium that results from the discount that the option provides is called intrinsic value.

Intrinsic value (for a call) = Stock Price - Strike Price

Intrinsic value (for a put) = Strike Price - Stock Price

The remaining part of the premium, the part that accounts for speculative interest in the option, is called extrinsic or time value.

Extrinsic (time) value = Option Premium - Intrinsic Value

Out of the money options have no intrinsic value, so the entire option premium for out of the money options is made up of time value.

The further in the money an option is, the more the option premium is made up of intrinsic value. Deep in the money options are made up almost entirely of intrinsic value.

I will follow up with more lessons on options in the future. I just wanted to get you started with the basics of options. Please don’t go out there and trade options just yet unless you know what you’re doing. I promise it will be well worth the wait.