If you’re new to stock option trading, you’re probably asking yourself, “What the heck are stock options?”
For those of you who don’t know all of the terms and definitions, this post is for you.
So what are stock options?
A stock option is a contract or agreement that gives the options holder the right but not the obligation to trade a certain stock for a certain price, by a certain date.
There are two kinds of contracts: calls and puts.
Call options are contracts given to the stock options holder when the market is expected to rise.
Put options are contracts given to the stock options holder when the market is expected to fall.
Calls and puts are also referred to “bullish” (call) and “bearish” (put).
How does it work?
So let’s give a real life example.
Let’s say that Jenny is selling her house for $300,000. She’s got a beautiful big backyard, great for a young family with children to play in. But what she doesn’t know is that there is a world-class golf course expected to be built backing onto her beautiful backyard, thus raising her house’s value to $600,000.
Along comes Chris…
Chris offers Jenny an option to buy her house for full asking price ($300,000) + a premium ($10,000).
So Jenny is happy because not only is she getting full asking price of her house, but an additional $10,000.
The house is to close on the 3rd Friday of the month.
Jenny accepts the offer and starts packing! Chris gives Jenny $10,000 for the option of buying her house (premium). If the house closes on the 3rd Friday of the month, Jenny will receive the $300,000 + $10,000. If it doesn’t, Jenny still keeps the $10,000 premium.
The thing is, Chris doesn’t actually want to buy Jenny’s house and wants to sell the option to Mike.
Mike buys the option to buy Jenny’s house at $300,000 from Chris for $15,000.
So Chris earned $5,000 on the deal with Mike. ($15,000 – 10,000 = $5,000 50% profit)
The house closes and it is now Mike’s house.
- Strike price: $300,000
- Expiration date: 3rd Friday of the month
- Option: call
- Option premium: $10,000 for Chris… made 50%
- $15,000 for Mike… made 90.4% [(600,000-315,000)/315,000] (on paper)
- Jenny is happy with $300,000 + $10,000
And everyone is happy.
Now let’s apply this to the options market.
- You now control 100 shares (one option) of SPY $276
- Your stock cost: (excluding commissions) $27,600 (strike price)
- Option cost ($1.50, controls 100 shares) $150 (premium)
- Stock rises $1… new value $27,700
- Option rises $0.50 (assuming .50 delta) $200
- Return on investment .36% 33.3%