Options

What are options? When would you use them? How do you make money on them?

Basic information

Derivatives are a group of investments that derive their value from an underlying security or rate. Derivatives are essentially a bet between two investors for which way an investment is going to move, one investor pays the other based on how things turn out.

Options are a security that is sold from one investor to another. The buyer of the option pays a premium to the option writer, the person selling the derivative. The buyer is given the right to buy or sell a specified investment from or to the other party at a predetermined price sometime in the future.

Aka, seller promises buyer that, as long as the option is valid, they will take the other side of a future buy or sell at a specified stock price for the underlying security, should they want to do so.

A right to buy a share from the option writer is known as a call, this means you are making a bet that the stock price will increase, by buying the option at a lower price and buying the stock at said lower price after it increases. Inversely, an option to sell a share at a set price in the future is called a put, you will be making a bet that the stocks price will fall.

Profitability depends on the strike price, the transaction price, and the market price of the underlying stock at or before the option's expiration. The closer you get to an expiration date, the cheaper it is going to sell for due to time decay.

Example call: You buy an option with a strike price of 40$ and the market price goes up to 50$, you exercise the option and gain 10$.

Example put: You buy an option with a strike price of 40$ and the market goes down 30$. You buy the stock at the cheaper price then sell it at the higher agreed upon price.

"In the money" refers to when the stock price of an underlying security (stock) is either above the call strike price, or below a put strike price. This would cause higher prices, as the option already has intrinsic value.

"Out of the money" is the opposite, it is when the price of a stock is below a call strike price, or above a put strike price. This would cause the price to be lower, as the stock needs to move further for it to reach.

"At the money" is an option that has a strike price relatively close to the current market price of a stock. This would cause the price to be on the more expensive side, but a median between in and out of the money options.

Important tip to remember when buying options

I learned this lesson that hard way the first time. While it may sound better to buy a lot of options that is so far out of the money insanely cheap instead of a few options, it is often more economical to purchase a call that is at the money or barely out of the money, as they tend to keep their intrinsic value.

If you are not certain 100% certain of a dramatic increase, tend to stay closer to the current price when possible.

Example: Buying 1 option for a 5.00 premium (500$), with a 50% increase in price to 7.50, will still net you 250$ profit.

*Note, American options can exercise the option to buy or sell the share at any time until their expiration date has passed. European options can only carry out the trade on the expiration date itself.