5 Basics of Options in 5 Minutes
Options are often the trickiest subject in the FINRA SIE exam, so we will be covering them early and often here on the Achievable Blog with the help of our partner Brandon Rith.
Today’s post is on the basics of options – it covers the concepts that Brandon outlined in his video by the same title: 5 Basics of Options in 5 Minutes. Check that video out for a video version of this post, otherwise let’s dive right in!
Options Basic #1: There are two sides to every trade
This may seem obvious, but this is another way of saying that every trade has a buyer and a seller. In the context of Options, this means that every Options trade, whether it’s a Call or a Put, has to have both a buyer of that Call or Put and a Seller of that Call or Put.
In trade terminology, someone who is entering a buying position is considered Long that position, and someone who is entering a selling position is considered Short that position. This terminology carries over to Calls and Puts – if you’re buying a Call, you’re placing a Long Call, and when you’re selling a Call, you’re playing a Short Call.
These positions and Options in general give you the ability to put your money where your mouth is when it comes to a stock you’re interested in. When you buy a Call (Long Call), you’re bullish on that stock or the market overall and think the price will be higher later. Conversely, when you sell a Call (Short Call), you’re bearish on that stock or the market and think the price will be lower later. In both instances, you’re trying to get a deal on the stock by locking in the price of the purchase or sale now.
Options Basic #2: Call = The Right To Buy
Options are a contract that gives someone the right to do something in the future under agreed-upon terms, sometimes in a specific timeframe. Calls are a type of Options contract that gives you the right to buy a stock at a later date for a price that you agree upon now. That right is valuable, which is why it must be purchased, typically for a Premium (more on that in #5).
If the Call buyer exercises his option to buy, the Call seller is obligated to fulfill the transaction at the agreed upon price.
Options Basic #3: Put = The Right To Sell
Puts are a similar mechanism to Calls, just in the opposite direction. Puts are a type of Options contract that gives you the right to sell a stock at a later date for a price that you agree upon now. Puts are often used to protect investments or gains that your holdings have made. Like Calls, Puts also typically have a Premium because you are purchasing the certainty that you can sell your stock at a fixed price at a later date.
If the Put buyer exercises his option to sell their shares, the Put seller is obligated to fulfill the transaction at the agreed upon price.
Options Basic #4: Options are either I.T.M (In The Money) or O.T.M. (Out of The Money)
Being ‘in the money’ is a term you may have heard before in poker. Its meaning in Options is straightforward: if your Options contract is profitable to you as it stands now, you are “in the money.” This means you will make money by exercising that Option contract immediately.
That said, savvy investors don’t always want to exercise contracts that are in the money right away – sometimes they think there are more gains to be made and are waiting for an even larger profit.
Conversely, if your Options contract is out of the money, that means that you would lose money if you exercised your contract immediately. This means that if you bought or sold shares on the open market instead of using your Option price and order, you would get a better deal. Generally, you do not want to do this unless you are afraid that things can get even worse.
Options Basic #5: The Option Premium is the Cost of the Contract
As Brandon says in his video, nothing is free in finance. This notably includes timing, price, and risk – if you want certainty in any of those factors, you should expect to pay for it.
Options give you the power to buy or sell a stock at a fixed price. That’s valuable.
When you are buying a Call or a Put, you buy at a small Premium from the Seller. That pays for their risk: when you sell an option, you’re getting paid to potentially do something that you don’t want to do at a later date.
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