The wealthy have always known how to put their money to work in new and creative ways to protect against risk of loss and to increase the likelihood and size of gains. The stock market in an incredible place for regular people to grow their money and increase their wealth over time. Yet the stock market, like the Forex market, Real Estate, Commodities, and Futures markets is only “two dimensional.” In other words, gains only happen if the market moves in the forecasted direction. If you buy a stock, that stock must rise in value to show a profit. Yet the stock market can move in three directions…up, sideways, and down. Buying a stock gives you only 1 of 3 chances of being right.
On the other hand, options can be structured to make money whether the underlying goes up, down, or sideways. We call this “three dimensional” trading because it provides a chance for profits regardless of market direction. How would it feel to know you can make money if the stock goes up, down, or sideways? Options do a much better job than stocks of increasing your leverage, decreasing risk, protecting assets, generating wealth, and cash flow generation.
Options on equities like stocks or futures are contracts between a buyer and a seller just like contracts in real estate. Stock options have been around for decades but not in the easily traded, inexpensive, and highly liquid market we have today. The groundbreaking formula used by market makers to price options fairly was developed by Robert C. Merton and Myron Scholes in 1973. This formula, now known as the Black-Scholes formula, was so foundational in creating today’s options markets that it eventually won them a Noble Prize in 1997.
All contracts have similar features. There is a buyer and seller. There is an agreed upon contractual price written into the contract. There is an expiration date. There are terms in the contract which the seller is obligated to abide by and the buyer can choose to exercise if they want. There is also money paid by the buyer of the contract to the seller of the contract (which the seller can keep even if the buyer doesn’t exercise their rights) to seal the deal.
Probably the easiest way to understand option contracts is to compare them to a real estate contract as an example. In a real estate transaction, the owner of a home decides they want to sell at a price they think is fair (let’s say $100,000). Now let’s say a buyer decides they like the house and want to buy it at the listed price.
Buying a stock would be like the buyer walking up to the seller of the house with enough cash to pay for the property outright on the spot while the seller literally moves from the house immediately. Options are more like a normal real estate transaction. Instead of cash, the buyer and seller enter into a contract with specified terms both can agree to. If the seller accepts the buyer’s offer, the buyer will provide cash in the form of earnest money to the seller. This earnest money is for the seller to keep whether the buyer follows through on the purchase during the life of the contract or not.
Normal terms in a real estate deal include the contracted sales price for the home, a date in the future when the contract expires, how much earnest money is paid to the seller, the seller’s obligations, and the buyer’s rights.
From the buyer’s point of view, putting a home under contract is an inexpensive way to give them some time to decide if they really want to follow through and buy the home. By having a home under contract, they now in essence control the home. This control gives the buyer the right to re-market the home and perhaps be able to make a profit without ever actually having to purchase the home.
From the seller’s point of view, a contract with a buyer gives them peace of mind that they will be able to sell their home at a price they like. The earnest money is theirs to keep, no matter what, as cash compensation for taking their home off the market during the life of the contract. If the buyer doesn’t follow through and actually purchase the home, the earnest money gives the seller recompense for the obligation of taking their home off the market while the buyer did their due diligence.
When entering into a real estate contract, the buyer has specific contractual rights and the seller has specific contractual obligations. And so it is in the options world. Those who “buy to open” an option contract have rights, as stated in the contract, and for these rights they pay the seller a fee known as a premium. Those who “sell to open” an option contract get paid the premium for which they obligate themselves to the terms of the contract.
The main terms to understand in the world of options contracts are:
Call Option: The option that gives the buyer of the contract the right to buy the underlying but obligates the seller of the contract to sell the underlying at the terms specified in the call option contract.
Put Option: The option that gives the buyer of the contract the right to sell the underlying but obligates the seller of the contract to buy the underlying at the terms specified in the put option contract.
Strike price: Similar to the price of a home in a real estate contract. This is the contract price both parties agree to. So if on the date of expiration the stock is at this price or better, the seller of the contract is still obligated to sell their stock at the contracted price and the contract buyer still has the right to buy the seller’s stock at the strike price listed in the contract. In practice, most option buyers don’t actually buy the stock…they simply sell the contract back to the market maker before it expires to capture their profit without having to come up with the cash to buy the stock.
Premium: Similar to earnest money, this is the amount an option buyer will pay the option seller. Think of it as the cost of the contractual agreement. Premiums will gain value or lose value based on the movement of the underlying equity and the mathematical application of the Black-Scholes formula. Premiums paid to buy options are usually priced at a fraction of the cost of the underlying and are therefore a less expensive way to speculate on a stock move. Options buyers like premiums to rise as it gives them a profit without having to spend the money to buy the stock…sort of selling a home you have under contract to another buyer without actually having to pay for it first.
Expiration: The date on which the options expire. For LEAPS options and monthly options this date is effectively the third Friday of the month since that is the last day they can be traded. For Weekly options which are created each Thursday or Friday, the expiration date is the following Thursday or Friday. The biggest risk to options buyers is that their option will expire before the move happens. If the underlying hasn’t made the expected move by expiration, the option will expire for a loss.
Bid: This is the wholesale price of the option’s premium and the amount an option seller will receive in return for entering into the obligations of the contract.
Ask: This is the retail price of the option’s premium and the amount an option buyer will pay in return for the rights they receive according to the contract.
Spread: This is the difference between the bid and ask price of an option. This is the money the market maker receives to make a market for that option. When confused as to which price you get (either the bid or the ask) just remember that you get the one that’s less profitable for you. Also remember that if you buy to open an option position, your trading account will show an immediate loss equal to the price of the spread. This is normal so don’t be surprised.
Options Chain: The list of all the options available for a stock. Usually organized by option type (put or call), strike price (lowest to highest), and expiration (nearest to most distant).
Buy to open: This is a directional trade. The buyer of the contract pays the contract’s listed Ask price (the premium) to obtain rights. If the option appreciates in value, the buyer of the option contract can either exercise their rights or they could instead sell that option back for a profit any time until expiration. When a “buy to open” order is initiated by a trader, takes the other side of the trade by initiating a “sell to open” order. Most option buyers choose to sell their contract before expiration to avoid the hassle and expense of exercising their contractual rights. Closing out a “Buy to open” position is simply done by initiating a “sell to close” order with the same expiration, number of contracts, and strike price.
Sell to open: Unlike contracts in the real estate world, options can also be “sold to open.” The seller of the contract gets paid the listed “Bid” price (the premium) and enters into contractual obligations. This is the method one would use to generate cash flow from owned stock or even on options one has purchased. This a type of trade that makes money if the stock moves in the forecasted direction, stays the same price or even drops a little. In this case, the premium is received from the market maker who initiates the “buy to open” position opposite of the one being “sold to open.” The seller of this option can remove the obligation anytime by initiating a “buy to close” order with the same expiration, strike price, and number of contracts initially they initially sold to open.
Buy to close: If a person who “sold to open” a position decides they want to remove the obligations they entered into when they initially entered into this contract, they can do so any time by simply entering a “buy to close” order with their broker. Using a buy to close order means a person does not need to remain obligated to the terms of the contract if they decide to remove those obligations.
Sell to close: Similar to a buy to close order, this allows someone who entered a “buy to open” option position a way to close out the position at any time until expiration. This order removes any rights acquired when initially opening the order.
In-the-money: Despite the complicated formula that determines an options fair price, options really only have two basic components that make up their value: (1) Extrinsic value, and (2) Intrinsic value. Extrinsic value is the part of the option that measures the value of the amount of time purchased. Intrinsic value is the part of the option that measure the “in-the-money” value which is always either a positive number of zero. Intrinsic value is determined by finding the difference between the strike price of the option and the current price of the stock. Because call options give the buyer the right to buy the stock, Intrinsic value is measured by subtracting the strike price from the current price of the stock. For example, if the stock traded for $100 and the call’s strike price was $90, the call buyer has the right to buy stock for $10 less than the current price which gives them $10 of intrinsic value ($100 – $90 = $10). It’s the opposite for put options. Because Put options give the buyer the right to sell stock, intrinsic value is determined by subtracting the price of the stock from the strike price of the option. For example, if the stock traded for $100 and the put’s strike price was $110, the put buyer has the right to sell the stock for $10 more than the current price which gives them $10 of intrinsic value ($110 – $100 = $10.) In-the-money options are always the most expensive because both intrinsic value and time value are positive numbers.
Out-of-the-money: Options that are “out-of-the-money” don’t have any intrinsic value and their premium is comprised only of extrinsic or time value. Out-of-the-money call options have strike prices above the current price of the stock while out-of-the-money put options have strike prices below the current price of the stock. Out of the money options are always the least expensive options because intrinsic value is zero and extrinsic value is the only positive number.
At-the-money: Options that are “at-the-money” are closest to the current price of the stock. Strike prices will move in and out of at-the-money status as stocks move up and down. At-the-money options might also be either “in-the-money” or “out-of-the-money” and are always the most expensive options in terms of time value.
Time Decay: The extrinsic part of an option’s premium loses value as time passes. This is known as time decay. It’s important to note than an option’s time value does not decay at the same rate for every day that passes. Time loses value faster as it gets closer to expiration. One good strategy is to close out the position 2-3 weeks before expiration on monthly options to avoid significant loss of value due to time decay.
Implied Volatility: Market makers inflate the value of time based on market demand. This is measured by implied volatility. It’s important to always be aware of how much one pays for time. Any loss of time value can only be made up by an increase in intrinsic value. For example, the stock trades at $100 and the premium for the $100 call option that expires in 30 days is listed as $10 because of some recent volatility. In this case, the $100 call option is “at-the-money” because the strike price equals the stock price. This means that the full $10 premium is for time (no intrinsic value). For this option to be profitable before it expires, the stock has to rise enough to the $10 lost to time decay and even more to generate a profit. It’s possible for a stock to move in the forecasted direction and still lose money on an option if implied volatility was high and the time value for that option was expensive.
Other things of note:
The two biggest risks with options are: (1) Time decay, and (2) Expiration. Like when buying stocks, an option buyer can lose 100% of their investment. It’s easier to lose 100% of an option than a stock because of option expiration. However, options are much less expensive to get into than stocks, especially for the more expensive blue chip companies and options move much faster as a percentage than stocks do. A 10% move in a stock can equate to thousands of percent move in the option…though a good rule of thumb is that options will gain about 10 times what the stock does.
Call options are often used as stock substitutes. For a fraction of the cost of buying the stock, a speculator can buy the option contract instead and then control the shares. This leverage creates some interesting possibilities when combined with other option strategies which we’ll get into later.
Put options are often used as insurance to protect against loss. Put buyers may choose to buy insurance on stocks (or other options) they own but they can also buy insurance on stocks they don’t own. Puts give the average investor a great way to participate in bear markets.
Options that expire up to 3 years out (LEAPS) and monthly options are set to expire on the third Saturday of the month. This is important to know because it’s possible that an option will close out on Friday with a profit but then some aftermarket news causes a loss in the options. Protect against this risk by closing out options positions no later than by market close on the Friday before expiration.
Market makers create new option expiration dates as time passes. They also create new strike prices as stocks move up and down in price. There will always be option contracts available above and below the current price of the stock and for expiration dates out into the future.
There are about 6,000 stocks that have options. Some of these stocks also have options that expire up to three years in the future. These longer term options are known as LEAPS and are often known as stock substitutes.
In 2005, market makers created Weekly options on about 400 of the biggest, most highly traded, and liquid stocks and ETFs in the market. Recently, market makers have begun experimenting with options that expire 3 days a week (Monday, Wednesday, and Friday) on the highly liquid SPY ETF.
Both put and call options can be traded either as “buy to open” or “sell to open” orders. Those who “buy to open” an option are “two dimensional” similar to those who buy the stock because the underlying must move in the forecasted direction to become profitable. This means that the underlying must move up enough to overcome time decay for call options or down enough to overcome time decay for put options.
While options add additional complexity to a trading strategy, they provide a great deal of flexibility and open up additional ways to profit from or protect against expected moves. Certain options strategies are also used to generate weekly income for those who want to continue growing their retirement even as they are in retirement without cannibalizing their nest egg or risk running out of money before they run out of life.
The options market has become a popular place for traders of all kinds and all skill levels to hedge risk, generate steady cash flow, diversify, or even catch up a retirement with amazing percentage gains compared to the same gain in a stock. While it is possible to lose 100% of the investment if the option expires before the expected move happens, options cost only a fraction of the underlying equity so the total risk is still less than owning stock.
The options market trades faster and is more complicated than simply sticking with stocks. But once learned, the benefits of using various strategies to help you achieve consistent and steady success from the markets is well worth the initial steep learning curve.