Lesson 1: Learning how options work

An option is a type of investment whose value is linked to the value of another asset. For stock options, the linked asset is a specific stock.

Each option is an agreement or contract between two parties that gives the option buyer the right to buy or sell a specific asset. There are two types of options: calls and puts.

• Buying a call option gives the right to buy shares of a stock at a specific price, known as the option’s strike price, by the option expiry date.
• Buying a put option gives the right to sell shares of a stock at a specific price, known as the option’s strike price, by the option expiry date.
• Since an option is a contract, there is an option seller for every option buyer. If you buy a call option, the seller of that call option is obliged to sell you stock at the strike price. If you buy a put option, the put option seller is obliged to buy the stock at the strike price.
• Lessons 1 through 6 of this course focus on option trading from an option buyer's point of view. We’ll cover option trading from the seller’s point of view in later modules.

Let’s explore some examples. We’ll refer to imaginary stock XYZ, XYZ call options and XYZ put options.

Stock XYZ is the linked asset, so the value of an XYZ call or put option is based, among other things, on the stock price of XYZ.

In general:

• When XYZ stock increases, the value of an XYZ call option tends to increase.
• When XYZ stock declines, the value of an XYZ put option tends to increase.

The price of XYZ call options generally rises when XYZ stock rises because of what’s agreed to in the option contract.

When buying a call option, the call buyer purchases the right to buy a specific number of shares of XYZ for a specific price until a specified date. The option is a contract that guarantees the call buyer a specific purchase price for XYZ until the option expires. Let’s illustrate this using an example from everyday life. We can compare calls to a more familiar product — grocery store coupons.

Call options resemble grocery store coupons

You can compare a call option to a grocery store coupon that expires sometime in the future, let’s say in 30 days. Imagine the coupon lets you buy coffee for $12 per bag. This coupon is not very valuable when coffee is selling at $11 per bag. But if the price of coffee rises to $13, $14 or more, the value of your $12 coupon will increase.

Imagine if coffee soars to $100 per bag. Your $12 coupon lets you buy coffee at a much lower price, so the coupon becomes extremely valuable. As the price of coffee rises, it makes sense that the value of the $12 coupon also tends to rise. You can hang on to the coupon for now and use it to buy coffee at a discount before it expires. Of course, this is only a benefit if coffee prices stay above $12. You could also sell the coupon to someone else, and they could use the coupon themselves or resell it with the intention of turning a profit. Call options work in a very similar way.

Note an important difference between grocery coupons and options: buying an option will cost you something, while grocery coupons are free. We’ll discuss options pricing in detail in lesson 2.

Let’s expand our definition of a call option

As we said, a stock option is an investment product whose value is linked to the value of a specific stock. The call option is a contract that gives the option buyer the right to buy a specific number of shares of a particular stock at a specific price. Because of this right, the call option price tends to increase as the stock price increases.

The contract also has an expiry date and must be used on or before that date. As a result, the call option can lose some of its value as the expiry date approaches and possibly all its value on the expiry date if it’s not worth using.

In lesson 2, we’ll learn how the price of an option is affected as it gets closer to its expiration date.

For put options, the reason that the price of XYZ put options rises when XYZ stock declines also relates to what’s agreed upon in the put option contract.

When buying a put option, the put buyer buys the right to sell a specific number of shares of XYZ for a specific price until a specified date. Because the put contract guarantees a sale price, a drop in the market price of XYZ makes the put more valuable. For example, in the extreme case that XYZ loses 99% of its value, a put purchased before the drop becomes very valuable as it guarantees a sale price at a higher level.

We can illustrate the concept of a put with this story of a corn farmer. One day, he’s out in the field checking on his crops. He has great-looking corn this year and he’s happy that corn prices are high right now. He would sell his corn now but, unfortunately, it’s not ready to be harvested.

A local grocer is willing to buy the farmer’s corn for $7 per bushel at any time in the next 30 days.

• The farmer signs an agreement with the grocer — the farmer pays something to enter into this agreement — and locks in the right to sell his corn for $7 per bushel. If corn prices move higher by harvest day, the farmer isn’t obliged to exercise his “option” to sell his corn for $7 per bushel, but he has that protection if corn prices fall to, for example, $5 per bushel.
• On the grocer’s side, if the farmer shows up with the corn during those 30 days and wants to exercise his option, as defined in his agreement with the grocer, the grocer is obliged to buy the corn for $7 per bushel.

As with calls, the put option has an expiry date and loses some of its value as expiry day approaches and possibly all its value on the expiry date if it’s not worth using.

Call option

Buying a call option gives the right to buy the underlying security at the option’s strike price until the option expiry date. You’re not obliged to buy the shares, it’s your choice.

Put option

Buying a put option gives the right to sell the underlying security at the option’s strike price until the option expiry date. You’re not obliged to sell the shares, it’s your choice.

Option premium or option price

The premium of the option is its trading price or what you’ll pay to buy that option. This is also called the option price.

Underlying security or the linked asset

The underlying security is the linked asset that an option contract gives the holder the right to buy or sell. We’ve been using the example of coffee, corn or stocks. This could also be currencies or an index.

Strike price or exercise price

All options have a strike price. The strike price is the price you can buy (in the case of a call) or sell (in the case of a put) the underlying security, or linked asset.

In the grocery coupon example, the coupon lets you buy coffee for $12. This is the strike price or exercise price, because the coupon guarantees you’ll pay that price for coffee if you use or “exercise” the coupon.

In the same way, a call guarantees the purchase price — also known as strike or exercise price — of stock XYZ for the call buyer.

For a put, the strike price is the price at which the put buyer is guaranteed to be able to sell stock XYZ.

In the corn example, the agreement between the farmer and the grocer let the farmer sell corn at $7 per bushel — this is the strike price.

Expiry date

All options have an expiry date, which is the final day the contract can be traded or exercised.

Back to the grocery coupon example.

• If your $12 coffee coupon expires in six months, there’s time for coffee prices to potentially increase above $12. In other words, your coupon has time to become more valuable.
• If your coupon expires tomorrow, there’s hardly any time available for coffee prices to move higher.

So, “time until expiry” plays an important part in determining how valuable your coupon is. The same is true for options. Options have an expiry date, and the price of options that have more time to expiry reflects that extra value.

Remember, though, that a greater time left to expiry is not a guarantee that your option will increase in value and move above the strike price by expiry. Many traders will sell their options before expiry and take a gain or loss, depending on the circumstances. If you hold your option until expiry, it must close above the strike price for a call, and below the strike price for a put, to be worth something.

Exercise style

Exercise style determines when you can exercise an option.

• American-style options can be exercised any time on or before the expiration date.
• European-style options can only be exercised on the expiration date.

Note that we’re discussing exercising the option, not selling the option. Either style option can be sold on or before the expiration date.

Most stock options are American-style while most index options are European-style. American- or European-style has nothing to do with geographic location but refers only to the settlement style, as just described.

Settlement style

Physically-settled options are option contracts where settlement requires actual delivery of the underlying asset. If you exercise your call option, you receive the stock. In the coffee example, if you exercise your coffee coupon, you receive the physical asset, the bag of coffee.

Cash-settled options are option contracts where the settlement doesn’t involve receiving the actual underlying security. Instead, you receive the cash value of the option at the time of expiration. Most index options are settled this way.

The contract multiplier and understanding option price quotes

When you buy one call contract, you’ve typically acquired the right to buy 100 shares of the underlying stock at the option’s strike price. If this was a coffee coupon, one coupon would give you the right to buy 100 bags of coffee. In other words, the contract multiplier is usually 100.

This is important to understand because it determines both what you’re buying and the cost of your option trade.

An XYZ call option quoted at a $5 premium will cost you $500 per contract and give you the right to buy 100 XYZ shares at the strike price for each call you hold. The calculation is:

Your cost to buy one XYZ call option

= $5 (quoted call price or premium) x 100 (contract multiplier)

= $500 (plus commission)

Next up is Lesson 2: Where does an options price come from? We’ll explore the concepts of time value and intrinsic value.