Options 101: Option Trading Basics – The Ultimate Rookie’s Guide
- Hello and welcome to the Options Course, The Rookies Course on Option Trading. My name is Brian Overby, I am the senior options analyst at Ally Invest, and I'm also the author of "The Options Playbook." Today's session is going to be Options 101, the basics. We're gonna get into the vernacular of the options marketplace and lay a solid foundation for the next two days. This is gonna be a three-part series. So tomorrow what we're gonna see is options 201, which will be the mechanics of the marketplace.
We'll get into the guts of option trading and talk a little bit about the pricing of an option contract. We'll talk about rights and obligations, and then we'll come back on Thursday, same time, 2:30 PM Eastern time, and we'll talk about the strategies. Now, whenever I talk about a rookie's course, I want to lay a solid foundation before we even think about strategies or actually placing a trade on options. Now I'm gonna highlight the fact that this is for everyone. Share this link, whoever you might think would benefit from a rookie's course on option trading. It's ally.com/optionsforrookies, it's free for all.
So with that said, let's get into it. What is an option contract? Now, before I define an option contract, I want to lay the groundwork here. Whenever I do a lot of basic option seminars, I'm always a little bit nervous that people are going to approach the seminar with the idea that, oh, I'm gonna learn about option trading to speculate and get rich using the leverage factor of an option contract. And that options are only used for speculation. If you take that approach on the very basics of option contracts, you'll never completely understand them. Options have been around since the 16th century.
The Dutch aristocracy actually traded option contracts on tulip bulbs, that was the very beginning of it. Overall though, with options, they were actually built out of a need to protect valuations. So what happened with the tulip bulb craze way back in the Dutch aristocracy, way back in the 16th century was, they were buying option contracts, which would be called Put option contracts to try to set a valuation to protect the downside of that marketplace overall. And then over time, they were used more by farmers, you think about futures and options together, to try to set a value, a guaranteed price that they can get for their crop.
That also means that there were people that were selling these option contracts to the farmers, to the tulip bulb purchasers overall. And a lot of that came from the insurance marketplace overall. And as we get deep into the basics of option trading, and today the vernacular, you'll see that there are a lot of terms that are used in the options marketplace that go along with the insurance marketplace. First of all, we mentioned that options are contracts, as you see right on our screen. And when you think about a contract, somebody has to write that contract. You buy a car insurance policy from a company, what do you reference that company as? You Call them the underwriter of that insurance policy.
If you sell an option contract, you're referred to as the writer of the policy quite a bit too. If we get into the price of an option contract, guess what we Call the price of an option contract? We call it the premium for that option. Guess what, when you pay for your car insurance, they say you're paying your insurance premium. And tomorrow we're gonna come back and we're gonna look at pricing, and you're gonna realize that a lot of the concepts in pricing an option contract come directly from the insurance marketplace as a whole.
So bottom line, the moral to my little introduction here is that if you're thinking about options, think about what they were first intended to do, which is to protect overall. And that will help you build the foundation that we need to start talking about option strategies in general. So what are options? Options are contracts that give the owner the right to buy or sell an asset at a fixed price for a specific period of time, and then obligating the seller to take the opposite side, if and when the right, embedded in the option contract, is exercised by the owner.
Okay. So, that's the body of an option contract. Bottom line is, this is all written out. And back in the day when you were trading options, you would actually get a physical contract that would have all of these words in it.
Nowadays, all we need to do is look at the quote. So I have an example of two quotes here. I have a quote for a Call and I have a quote for a Put, which we're gonna define here in just a second. But those are basiCally the two flavors of option contracts. And inside this quote, it basiCally lays out all the terms and conditions to that option contract, but it does it in shorthand. So we're gonna walk through this quote and we're gonna define every little component, whenever you see a quote on an option contract and what that is actually telling you.
All right, so let's get into the two flavors of option contracts. We have Calls and we have Puts. Calls are much easier to understand than Puts, but in general, Calls are options to buy an underlying stock.
And we're only gonna talk about stock options today. I may mention index options every once in awhile, but when you think about a stock, that means that you were talking like companies like Walmart, Apple, IBM, all these different companies overall. And that's what we're gonna focus on today. There are different options that you can trade, but we want to keep it as simple as possible today.
The other option contract are Puts. Puts are options to sell an underlying. The buyer obtains a right, but not the obligation to sell the underlying stock.
So if I buy a Call, my intention is to buy stock. If I buy a Put, my intention would be to sell stock. Now, where do the terms Call and Put come from? And I'm gonna point to them on the screen here.
Call actually means that I'm Calling stock away from somebody. So when I'm buying stock from that person, I'm Calling it away from them. And then a Put option contract, over here is, I'm actually putting stock to someone. It means I'm selling it. That's where the term Call and Put come from.
Now, we always say underlying stock, because when you think about an option contract, it's all based off of that particular stock that it's trading on. And so we Call that the underlying stock overall as a generic term. So in our instance here we have XYZ, which is a fictitious stock.
We have the January 70 Call option, that means we have the right to Call stock away from someone. And that's trading at $3.10. So we'll get in a little bit more detail what $3.10 means.
Then we also have a February on stock ABC, that's the underlying. 35 strike Put, that means we can Put stock to somebody. Now that means we have to be the buyer of that option contract.
Now, if we're the seller of the contract, that means we're gonna take on an obligation. And that obligation is gonna be the opposite of the buying, right? If I buy a Call, I have the right to Call stock away. That means that the person that sells me that Call has the obligation to sell that stock to me. If I buy a Put, that means that I have the obligation to Put stock to someone, to sell them. And that would also mean that that person that sold that Put has the obligation to buy that stock overall. All right.
So Calls and Puts, the two flavors of option contracts, in general, that are out there. So we mentioned underlying. Now, what does underlying mean overall? Now realize, and also want to keep emphasizing that this is in the terms of the contract.
We're seeing a quote, we're seeing a very short contract basiCally laid out for us. Options are customarily on one underlying. Equity option contracts ordinarily represent 100 shares of the underlying stock.
There are many different types of underlyings, but I'm only gonna talk about equity options today or stock options. Now I did also Put this in here because I've already said it once, stocks are sometimes referred to as equities, meaning that you have equity in the company if you own a share of stock. You are a part owner, you have equity.
So sometimes securities or stocks can sometimes be referenced to as equity in that underlying stock. So here in this instance, we have stock XYZ. And this stock XYZ means if we buy this contract, that this contract is going to represent 100 shares of XYZ overall. We're looking at a Call option on XYZ, that means we have the right to buy 100 shares of XYZ. On the Put side, we have a Put option of ABC, that means we have the right to sell 100 shares of ABC.
Now, if you notice up here, it says options ordinarily represent 100 shares of stock. There can be situations where an option contract doesn't represent 100 shares of stock, but that's usually caused by an action by the company. In other words, maybe a company got bought out, maybe they did a weird stock split that changed the price of the actual underlying stock.
Also a reverse stock split, which increased the price of the underlying stock. Those situations may cause a contract to be adjusted and not represent 100 shares of stock. Bottom line is, in the listed options marketplace, almost all contracts start as representing 100 shares of the underlying, which is gonna be important later on when we talk about the price. All right, so rights and obligations.
These are kind of intuitive terminology, but this is all about the basics, right? So we need to define them here. We talked about rights and obligations already. So how do I exercise my right? I would actually Call my broker and say, I want to exercise my option contract. So when exercising an option contract that was bought, that means an owner of an option invokes the right embedded in that option contract.
It's called exercising the option. The owner buys, if a Call, or sells, if a Put, the underlying stock at the strike and requires that the option seller take the other side. So it comes down to buyers get rights, sellers take on obligations. If I am an owner of a contract, and I want to invoke my right, I Call and say I want to exercise. Once I say I want to exercise, unless somebody does that, or the exchange does it for someone overall, we'll talk a little bit about that tomorrow, then that creates an assignment.
So we can not have an assignment without somebody exercising overall. So once I'm assigned on that option contract, that means the receipt of an exercise notice by an equity option seller/writer, slash writer, that obligates him or her to sell in the case of a short Call, or buy in the case of a short Put, I've sold that Put, shares of the underlying stock at a predetermined price per share. Now, there's two words in here that I haven't defined yet. And I feel all of a sudden feel like I should. If I sell a contract and I've already sold it, in other words, I called my broker and say, I want to sell this option contract, once I get that contract executed, I am then considered short that option contract.
So the seller trades with the trading floor, the trade gets executed. I then become short that option. As opposed to a buyer, when I buy that contract, after that contract gets executed by the trading floor, or another way would be filled, then I become the owner and I'm considered long that option contract overall. All right, so we have long and short, we have exercise and assignment covered. Let's get into the next component of that option quote.
Strike price. All right, very important, very important. This is the predetermined price at which the underlying asset should be bought or sold if the option actually is exercised. So in our Call option we have a 70 strike, in our Put option we have a 35 strike.
This means you have the right to Call stock away at 70, in our first example on XYZ, and the second example means that we have the right to sell or Put stock to somebody at 35 on ABC. Now there's an issue in the options marketplace, and it's gotten better over the years with the power of computing. But if you're trading options on XYZ, or let's just say, you're buying stock XYZ, there's just one stock, right? It's XYZ. You Put in the symbol XYZ, you say you want to buy 100 shares of it, you're gonna buy XYZ.
Well, in the options marketplace, there's potential for many different underlyings that you could trade. So, as we mentioned, an option is a contract. We need to define the number of underlying, the number of option contracts that can trade under the symbol XYZ, or that underlying. So in the options marketplace, the more offerings, the harder it is to get markets or find people to trade all those option contracts.
So they limit the number of strikes. You don't have one point strikes in all the underlyings. Like for example, if the stock's at 70, you might not have a 69, 70, 71, 72. If it's 70, that would fall in between the 25 and 200 interval level. And that means that you'd most likely have strike prices of five points. You would have a 70, 75, 80, et cetera.
Most of the time, also they will not open strikes and make them available for trading until the stock has actually traded at that level overall. So when you're looking at option contracts, the strike price is very important to you, but it's going to be limited as to the offerings overall. And part of the reason why, and we're gonna get more into this at the very end of this presentation today, but part of the reason why is that the more offerings you have, the harder it is to find people to trade all of those offerings overall. And if you want to have very liquid markets, you need to limit the offerings and limit the number of strike prices that are available to try to keep the market as liquid as possible. Easy to get in, easy to get out, make it a viable marketplace overall. Now, when I first started trading options back in the day, these intervals were pretty much set in stone.
They very rarely added one point strikes or even half point strikes overall. And the problem was quoting. It's hard to quote, every time the stock moves $0.25 or $0.30, you have to quote all
of these different strike prices that are available, and that takes a lot of computing power overall. With the advent of a better, stronger, faster computing power overall, we've seen the more strike prices that have been added. So if you have an extremely liquid underlying, and I'm talking stocks like Apple, the SPY, which is the ETF that tracks the S&P 500 index, it's one of the more liquid underlying stocks out there.
You'll sometimes see intervals of $1. So they haven't limited it to these rules, they only open up these strike prices if the marketplace can handle it overall. All right, so this is strike price, it's very, very important. We've spent a lot of time on it overall. If you have questions, please do Put them in the chat box.
We are going to be answering as much of them in chronologic, I'm sorry, chronological order at the end of the event. I'm gonna save 15 minutes for that overall. All right, so expiration. Many different expiration periods to choose from.
Bottom line is, as mom always said, time is money. The further you go out in time, the more time you have, the more expensive the option contracts going to be. We're talking about stock options here, so you'll see this word, American Style option.
In our world, this is all we're gonna talk about today on the basics of options all throughout the rookie's course, it's referred to as American style. It means it can be exercised at any point in time. If the marketplace is open and you can get a hold of your broker, you can Call up and you can exercise and buy that underlying stock if it's a Call or sell it if it's a Put. And it goes all the way out to that expiration date. Now, before the addition of weeklies, which are option expirations that expire week in and week out, all American style stock option contracts expired on the third Friday of the month. And once again, computing power added different expirations because the exchanges have the capability of quoting all these option contracts overall.
But now there are weekly option contracts, they've talked about daily option contracts overall. That's good because you have a lot of choices, but you also got to worry about the liquidity of the marketplace as a whole. You want viable markets in general. But that expiration date, for example, if we looked at our January, and I'll go down to the next bullet point, just referencing the Call, you might see a January 7 after the word January. J-A-N-7, or January 14. And then a lot of times we'll even Put the year in, especially when you get to your end, right? So January 14th expiration would be in 2022.
And that would be the last day to trade in and out of that option contract. And it would also be the last day to exercise your option contract, if you would like to do that, and buy the underlying stock. Now on the Call instance, that would mean that you have the capital to buy the underlying stock. You can't buy it without that capital overall.
So just keep that in mind. But if I'm trading options, that expiration date is like a coupon, right? You're all ready to go and get that discount on your ice cream cone, but then the person behind the cash register says, well, that coupons expired. Well in the options marketplace you have that same scenario where that might happen. Is it possible to Put in an exercise notice after the market closed? Yes, it is. We'll talk a little bit about that. As long as your broker's open up and they're acceptable, usually they'll limit, say, so the market closes at 4:00 PM Eastern time, usually you have about a half hour or an hour to get in an exercise notice.
If you wanted to do that, you could do that. You could give them a Call and let them know. But bottom line is, a lot of times option contracts don't make it to the expiration. Even if they have real value in them, a lot of people will trade that option contract.
So we're gonna talk about that before we get through this session of options 101. All right. So PM settlement just means that it's based off of the price on the close of the option contract.
Just another term that you should be aware of, if you see it out there. That means that if it is a January 14th expiration on our XYZ Call, you have until the close of the market on January 14th in order to trade or exercise your option contract. That would be a PM settlement. AM settlement comes in with indexes, so there obviously is an opposite of it, but we're not gonna talk about those today.
All right, premium. I mentioned as we began here, I mentioned on the introduction that when you talk about the price of an option contract, we're talking about the premium, that's what you'd pay for it. Just like in the insurance world. When I am paying for my car insurance, I'm paying the insurance premium.
So it's the price of the option, it's paid by the buyer, received by the seller. But the number of shares is really important here. And I'm highlighting it here on the screen.
Most options represent 100 shares. And in our little addition here, we're gonna say that all of our examples, they represent 100 shares. So if we look at this Call option, we see that the premium or the price is $3.10. That really means that it's gonna take $3.10 times each share. So if it's 100 shares and that's what the contract represents, you just take that 100 times 310, and you come up with $310 plus commission to buy that option contract.
On the Put option, if ABC, if it represented 100 shares of ABC, that means the 120 would be $120 to buy that option contract. And always got to add in commissions, still paying commissions in the options world, even though they've came down precipitously since I started in options about 30 years ago overall. So now, just gonna talk about these, we're not gonna get into the strategies, but to kind of recap, we talked about Call and Put options, so far, the two flavors.
We talked about buyers, we talked about sellers. So this is a little grid about the four basic positions that you can do in the options marketplace. If you are the buyer of an option contract, you're gonna have the right to buy. You're gonna pay money. And for that money you're gonna receive a right. That right's gonna be to buy 100 shares of the underlying.
And if you do it with a Put, that means you're gonna have a right to sell 100 shares of the underlying. Once I bought it, I'm considered long that position in my account, and then on the opposite side, that means somebody has sold that option contract. They take on an obligation, they receive cash, which is a good thing. I like cash now as opposed to cash later. But because of that, I'm gonna take on an obligation. And that obligation is going to be to sell the underlying 100 shares on the Call situation.
And on the Put situation, this means it's gonna be the obligation to buy the underlying 100 shares at that predetermined price or that strike price. Seller's often referred to as short, and because of the insurance vernacular that you use so often in the options marketplace, they're also considered the writer of that option contract overall. All right. So ins and outs. These are very intuitive situations, but we already talked about that there are many different strike prices that are available.
But let's start with just looking at, what if you had a stock that was right at the strike price of your option contract. So if you look at the X and Y axis here, the labeling is very important. If we started with a 70 strike Call, or I'm sorry, if we started with a stock at 70, because this is the price, this axis is, and you have a 70 strike Call, in the options marketplace we refer to that as At-The-Money.
If the stock goes up, and I know that these arrows are kind of hard to see on our screen, but I wanted to do the accounting method, in that, then you would be In-The-Money, which means in the accounting world, that you would be in the black overall. So that means I have some real valuation. So the stock was At-The-Money, now the stock has gone up 75, 80, now this option contract is considered In-The-Money. That also means that if I do this in terms of rights and obligations, let's focus on the stock being at 80.
If the stock was at 80, I would have the right to exercise my Call option at 70, and I could sell it at 80. Hence that would mean I would make $10 on that position and that would have real value, and that's called being In-The-Money in that scenario. Now, if the stock goes down, using red arrows, because I'd be in the red, right? The option contract was At-The-Money, now it is Out-Of-The-Money. So the stocks down at 60, if you think of rights and obligations, if I bought that option contract, I have a right to buy the underlying stock, not an obligation. So I don't want that obligation.
I don't want to buy that stock, right, because why would I buy it at 70 when I can buy it in the real world, in via the marketplace, at 60? So that option would be Out-Of-The-Money. There's no real value to it. If you were at the expiration date, you would just let it expire and you would move on to your next trade overall. So if I exercise, I buy it at 70, stock goes up, that's considered In-The-Money.
I can sell it at a higher price. If I exercise, I buy it at 70, stock goes down, well, then I would not want to buy it at 70 when I could buy it in the real marketplace at 60. So that's the Call side of things, and that's a little bit easier to understand. But Puts, I've always struggled with Puts overall. Even people just asking general questions about Puts, because a lot of people struggle with the concept that you're buying something with the intention of selling at a later date.
So if I'm buying a Put, I want the market to go down overall because I have the right to sell it at the strike price. And hopefully if the market's lower than where that strike price is at, well, then I can sell it higher by exercising my Put. So we see the black arrows on the way down.
Our example that we were looking at today is a 35 strike Put, stock's at 35, that's At-The-Money. Stock goes down to 25, you got to think of it in reverse now. I could buy the stock at 25, exercise my Put and then Put it or sell it to somebody at 35. So that would be 10 points In-The-Money there, and that's why that's considered an In-The-Money option contract. The underlying goes up, then we're in the red, to use the accounting term.
If it goes to 45 in this instance, well, there's no reason you'd want to exercise overall. Why exercise and sell stock at 35 when you could sell it in the real marketplace at 45. So that would be considered Out-Of-The-Money overall. All right, so I think at this point in time, I stop and I take just a smidgen of water, because we're gonna get into intrinsic value and time value overall.
Okay, here we go. So we mentioned that time is money. We've already talked about that. The further you go out in time, the more costly an option contract could be. So now let's get into, how do we figure out that valuation? So in our instance, I'm just gonna talk about Calls today, because they're a little bit easier for most people to understand.
But if I have a stock at 75, right, in this instance the stock is at 75, and I have a 70 strike Call option. We're not gonna worry about the expiration overall, it's just a 70 strike Call option. That's trading for $6.
So that's a real option contract, right? Represents 100 shares, that means it would be $600 to buy that option contract, plus commission overall. Stock price is at 75. You take 75 minus 70. It means you have $5 of intrinsic value, which is also known as In-The-Money amount.
You're In-The-Money about $5.00. You're not about, you're In-The-Money, exactly $5.00 on this trade. So we called it real value, now we're gonna put a term to it. We're gonna actually call that intrinsic value. But the option contract is trading for $6. So guess what? You take that $6.00, subtract the real value
or intrinsic value, and you come up with something called time value. Now in the options world, a lot of people will reference that as extrinsic value overall. So let's think about options and insurance and all this other stuff in general when we think about time value. Time value is important in your car insurance, right? If you want a six month policy, it's gonna cost you less than a one-year policy. And they're not going to just take on that obligation of giving you a new car if you happen to run it into a tree without receiving some capital now.
So whenever you pay for your car insurance, you're always paying time value. And if six months go by and you decide, well, you sell the car or something else like that happens, well at that point in time, then you get a refund on your six month policy. Because that three months that's remaining has value overall.
So they'll buy your policy back or close out that policy and they'll pay you for it because you no longer own that car overall. So in this instance, we had an option contract that had real value overall. In-The-Money, had intrinsic value.
But in this instance, the next slide, we're just looking at an option contract where we're gonna move the strike down based off of our in-and-out and At-The-Money example here. Now we're gonna move the stock price to 65. We're gonna have a 70 strike Call once again, but with the stock at 65, that Call's now trading for $1.00. So how much intrinsic value? Well, if you take 65 minus 70, you get -5, right? So ideally it's just zero, right? This option contract is 100% time value overall. So that's considered an Out-Of-The-Money option contract.
You can call it extrinsic, extrinsic value, but it's more oftenly referenced as time value, especially in beginning option circles in general. All right. I have a couple of questions that I want to use to start this, and we're gonna actually go and look at some real option chains and talk about them. We're gonna go to the Ally Invest option chains portfolio. But with that said, I got some things to think about that I want to send your way.
And my first thing to think about here is if I buy a Call option, looking at the first question, do I have to buy the stock at some point? And then let's talk a little bit about a Put option. So I want you to think about that. If I buy a Call option, do I have to buy the stock at some point? And then if I buy a Put option, does that mean I have to sell the stock at some point? So you've got the yin and the yang. And then nextly, I want... (laughs) Nextly, I guess that's probably a word. If nobody buys or sells an option contract that is being quoted, does it really exist? A little bit of the sound of one hand clapping stuff overall, right? So if nobody buys or sells the option contract that is being quoted, does it really exist? And then I'm gonna talk a little bit more about liquidity and why does that matter? So if you have the questions, please start putting them in the chat box overall.
And I need to reload a lot of the questions that are here. And I guess I'll address a few of these. Let's start with this. But I do also want to save some time to get to the option chains. So here's the very first question. One second, let me blow it up a little bit.
My eyes aren't what they used to be when I first started trading options. Could you explain the importance of the strike price again? Yes, I definitely can. That's a great con... Before I get to the option chains, I want you to know what the strike price is overall. If I look at the strike price of an option contract, that's what the option contract is all about.
You want to have real value. So if I'm buying a Call option, the predetermined price at which I could buy that underlying stock is called the strike price. So if the strike price in our example, and I'll page up a couple here, in our example we had, well, let's just use this. We had a 70 strike Call option. That meant that we have the right to buy the stock at 70, with the stock selling at 75.
Well, that's a good thing overall, right? That means we have real value. We don't know where we bought the Call option to start with, so that's kind of an issue here on this slide, but I have real value. I can buy the stock at 70, sell it on the marketplace at 75 if it's a Call option. How do you find the exact time when your option will expire? And you've got to know a few of the rules.
Okay, so here's the... The Magnificent asked this question. I don't know if that's your real name or not, but overall The Magnificent asks, how do you find the exact time when your option contract will expire? So if I look at the premium and I see this January 70 Call, if we look at a quote, which we are gonna go to a real quote, it'd usually have a date on it.
So if right here in our example on expiration, we show that to that date, and it'll usually have a year next to it. Now what you need to know is that that is the last day to trade the option contract. That's what you need to know. That's the last day that the option can be traded or exercised. And you've got to realize that at the end of the marketplace, that doesn't mean you have all day.
You can't call your broker at 10:00 PM Eastern time at night and say, hey, I want to trade out of my option contract. Silly enough, you might've been able to do that way back in the day before the listed exchange traded, because you were actually dealing with one broker when you were trading option contracts that were written overall. But with that said, normally next to the word January or J-A-N for short, or F-E-B for short, you will see a day and a year when you see a full quote on an option contract. And then if you were to purchase a Call at the strike price of 70, what would your position be? This one's from Larry.
If you were to purchase a Call at the strike price of 70, what would your position be if you paired a stop-loss at 50 with the Call? Is that technically selling short? If you purchase a Call option or a stop-loss. No, Larry, that wouldn't be selling short, selling short is something totally different. And in the third session, we're gonna address selling short.
We're gonna talk about the opposites of selling a stock short versus buying a Put outright. We're gonna talk about the good and the bad on each side of that transaction. You mentioned a stop-loss. I feel like I need to address it.
If I were to buy a Call with a strike of 70, in our example, which is a $3.00 option contract, a stop-loss would mean that I paid $3 for it. You can do a stop-loss on an option contract, just like you can on an underlying stock.
Which means that I can say if I paid $3.10, if I lose about half my money, it comes down to $1.50, I want to activate an order. That's called the stop. And send an order to the marketplace saying I'm willing to sell this at $1.50, if I picked a limit price, or sell it at market, whatever the next available price would be.
You can do that with stocks, you can do that also with option contracts. So a stop-loss has nothing to do with actually selling a stock short overall. Next, and that I'm gonna get into the... I've got a ton of questions here. So then I'm gonna actually go to the option chain just for a second.
Could you explain the difference between American and European? Why would you use American over European? Well, I wasn't gonna get into European, but European deals with index options. When you're trading index options... In order to answer your questions, the final question that you have here, Jamie, why would you use American over European? If I am trading an index option contract, and that's the S&P 500 index, and that represents approximately 500 stocks, not exactly, but approximately 500 stocks. What that would mean that if I exercised, I would be buying a basket of stocks, and I don't want to do that overall. So if I am looking at a European style option contract, that means that it can only be exercised at that expiration date.
So if we're talking about cash settled instruments that don't deal with stock, a lot of people don't want that. If I'm selling those option contracts, I don't want that obligation where you can just call cash away from me at any point in time between now and the expiration date. If I have a stock and I'm saying, I'm gonna sell a Call at a strike price above where the stock is trading, and it gets to that strike price, go ahead and Call my stock away.
I don't mind. I own the stock. I'm selling it higher. Go ahead and do that. That would be American style expiration.
And when you're dealing with stocks, there are many people that don't mind selling that Call option, saying you can Call the stock away. It's a much different situation than when you're in an index option and they're Calling cash away from you. Now, that's way more than I wanted to talk about index options overall, but that's where the term European comes from. I have no idea why it's American and European, there's much better terms, but then again, in the options world, there are a lot of odd terms, just in general, about option strategies and everything overall. So let me run to a chain, because I want to show you real life examples here.
We're getting here close to the end. And keep the questions coming. We got quite a few and I'm gonna try to address them all.
Hopefully I get through all of them before the end of session one here. And so I'm going to end this full screen. Let's get all the way down to the bottom, by the way, just so that we have it.
And then I am gonna go to the Ally Invest option chains. Now, if you want some required reading, you can buy the "Options Playbook." It's for sale on Amazon. But every single word of the "Options Playbook" is also on optionsplaybook.com. We're not in the book-selling business. So we're in the brokerage business, we're in the education business, we want people to learn option trading so we Put everything online.
There's a little rookie's corner section. There's one, two, three, four, five and options basics. Almost everything that I covered comes from options basic. And by Thursday, the rookie's corner.
That's when we're gonna talk a lot about these strategies that we mentioned overall. So now here's an option chain. Now I always have to emphasize, nothing's meant to be a recommendation. You're gonna be trading options. You should read a little pamphlet called the options disclosure document, put out by Chicago Board Options Exchange. You can see the link below the video here, and we put it in the chat box probably a couple of times overall.
But with that said, I'm just here to try to teach you. I want you to look at what an option chain... The markets are rocking and rolling, it's live.
I picked a stock that a lot of people know, Apple, could be Amazon, could be IBM, could be Walmart. It doesn't really matter because we're just gonna look at the basics of an option chain in a real marketplace overall. So I said, there's many different expirations to choose from. Apple is one of the more liquid stocks in the marketplace. Guess what? We have a lot of expirations to choose from.
The W's on the chains represent that these are considered weekly option contracts, as opposed to a standard option contract. The standard option contract, and all that really means, is the way we used to do it before we got the quoting power. That's the third Friday of the month.
That happens to be December 17th in this instance right here. So I have highlighted that monthly expiration. If it's got a W next to it, that means that that is a non-standard weekly options. But look at how far out in time we go.
All the way out to January of 2024. 780 days away in Apple. These are all the different strike prices that are available.
Now you can see that type of quoting power overall. Now we also have a strike range. So in our instance, we had very generic examples.
So here I can adjust the strike range by just moving the slider back and forth. And I need to emphasize, by the way, I don't know if I did, this is the Ally Invest live option chains. So these markets are rocking and rolling. And in this instance, we see Apple trading at 164.02. And here are the different strike prices. I don't necessarily need to go way deep In-The-Money or way deep Out-Of-The-Money.
So I've limited my range to 145 to 188. If I want to see a few more on the upside, that's all right, let's go to 195. Oh, we'll go to 200.
Okay, so I'm 145 to 200, and that's the range of strikes that are available. Now we have things like open interest and volume. Oh, those are big words.
They're very important to the options marketplace. We're gonna go into a great detail on it. But what's more important to me right now is to talk a little bit about the bid and the ask.
This is where liquidity comes in. If you're trading the underlying stock, we see that this is a penny-wide spread, right? If you want to buy a hundred shares of stock right now on Apple, you'd have to pay 164.00. I got to say it real quick before it moves. And if I were selling it, I would get one 160... Well, now it's already moved, 163.99.
It's one cent wide, very, very liquid market. If you want to trade a hundred shares of Apple, buy or sell it. But if you're buying, you're gonna pay a little bit more than if you're selling. And that's the reason, that's the incentive for people to make markets on Apple overall and why market-makers exist. So in the options world, if I look at one of the more active option contracts here, it's it shows the volume is a 11,870 contracts that traded on the 162.50 strike.
Notice they're two and a half point strikes in Apple on this monthly contract. That means it's $5.00 by five, well, 5.05, 5.10, it's jumping around. It means that if I'm buying it, I'm gonna pay 5.10.
And if I'm selling it, I'm gonna receive five. The marketplace is at least 5 cent wide, sometimes it's 10 cents wide. Now on a percentage basis, that's a lot different percentage relative to the underlying stock. So this is part of the reason why the Chicago Board Option Exchange and all the other option exchanges that trade option contracts limit to some rational number of strikes. In apple, it's very liquid.
$0.05 is not a bad market overall on an option contract. Now realize, that's $5.00 on 100 shares, $0.05 would be. And the more and more strikes in the more and more expirations, that volume gets distributed amongst all those different strikes and all those different expirations. And we saw all those expirations right here. If there are less expirations and less strikes, guess what, the marketplace is gonna be easier to get in and out of. And that width between the bid-ask is going to tighten up and be a little bit tighter.
And the less and less offerings that you have, the tighter and tighter the market would be. And that was the concept, especially when the Chicago Board Option Exchange first started trading options in 1973, I think was their first time trading options overall. They had very limited expirations and very limited strikes that were available to try to add to the liquidity of the marketplace. Nowadays, option trading has taken off.
And year after year after year they set new volume records overall. And I just think it's because people become more and more astute in the options trading world, you have more tools available to you. You have great educational events like this overall. It's easier to just go online and learn about these types of products and how they can help you enhance your options portfolio, or your portfolio overall. So kind of the moral of the story is, if I'm looking at this option chain, on the left-hand side I have Calls, on the right-hand side I have Puts.
We have bid-ask. We'll talk about last invol- Well, this is the last trade, just like on the stock. It's last trade, where it occurred at. We're gonna talk about volume and open interest a lot tomorrow.
And then we're also gonna mention Delta, which is a little bit of a more advanced concept, but helps us develop realistic expectations as to what our option price might move. Because you think about it, it's not gonna move like stock. If stock goes up one, you don't expect your option to go up one. It's derived from the stock price. The most that an option contract would go up, if you think about it, is what the stock would go up. That's what a derivative is all about.
It's not gonna go faster than the underlying stock overall. So that's one misconception some people have. And then applied volatility, that's a big component.
We'll get in and discuss it. On the other side of the coin here, we have Puts. Once again, we have the bid and ask, it's laid out the same way in last volume, open interest in Delta. But we scroll through the chains and you don't have the right to buy, or you don't want to spend $16,400 to buy 100 shares of Apple.
Well, you can rent Apple. And that's one way that we look at it on the Call side. We could go in and say, well, I want to buy one of these option contracts. And that means I'm gonna have the right to buy the underlying stock. Which the right to buy is good if the underlying stock goes up, right? So if I have the right to buy it at 165 and apple goes beyond 165, well, that's a good thing overall. The valuation of my option contract should then increase in price.
And because we have a fairly liquid marketplace, I could then sell that option contract. I could exercise, buy it at a lower price than where the current marketplace is at overall. And my last thing that I can do is actually, if it went down, I could let the option contract expire, knowing that I had limited and known risk overall. Now we're gonna talk about leverage. Gonna talk about those three things that we brought up over there. But let's get back to your questions.
And before I do that, I want to remind you that this is free for all. My name is Brian Overby. Let's Put this in presentation mode. Please follow me on Twitter. I tweet about all of the educational events inside Ally.
On Tuesdays, I do a stock play of the day, myself and a colleague of mine. One of the stock analysts usually join me. And we talk a little bit about an underlying stock and then we weave in some option trading and option trading strategy. So if you'd like to learn more about that, please go to ally.com/investeducation and you can sign up for the email list. We'll just send you out.
We will only send you one a week, usually. I don't even know if sometimes it might be one every other week. But it will tell you all about the invest education. If you don't want to sign up for an email, you can always just follow me on Twitter. I tweet about all of our events.
And then obviously you can go to optionsplaybook.com and learn more. So two more events coming up. I hope to see you tomorrow.
We have the 201 and we have 301 the next two days. They're all both gonna be about one hour long. And please bring your questions. We love that this is an interactive event.
All right, speaking of that, a better get to it. We got eight minutes left to answer some questions here. Okay, so next question. This one's from Charlie. Is selling of Calls or Puts less risky than buying Calls or Puts? Plus, do you get a premium on selling of Calls and Puts only? So I should probably start by saying that just in general, it's easy to buy Calls and buy Puts, and it's almost as easy to sell Calls and sell Puts.
So in the stock world, if you sell a stock, that's considered selling a stock short. There are a lot of headaches that are involved with selling a stock short, and that's one way that you could participate if you thought a stock was gonna go down in price. In the options world, it's easy to sell options.
We're gonna get into the vernacular of entering an order tomorrow. But there are a lot of risks that are associated in particular with selling option contracts. And I guess one of the ways to think about it is if you are an insurance agent and you sell insurance to your buddy on their car, think about the risk that's involved with that. They're gonna give you some money and it's not necessarily gonna be a ton of money, but you have a lot of risk if you sell just one insurance product on a Bentley overall. You get that money now, but you have that risk over that next six month policy of that Bentley getting ran into, or overall what might happen. So yes, you can have risks.
Now there's ways to mitigate that risk. And if we continue on with this event, we'll get into those more advanced strategies overall. But usually when you're selling options, just in general, in a vacuum, you're gonna have more risk than you are when you're just buying options outright. Alright, Ruby. In both of your In-The-Money and Out-Of-The-Money examples of extrinsic and time value, the time value was the same, one.
So what is the difference in the significance of time value? Okay, now I did do the time value as one on both of these, because we're gonna talk a little bit more about time value, but usually when you're equal distance in a theoretical world, if you're five points Out-Of-The-Money and you're five points In-The-Money, usually your option contract will have about the same amount of time value. Now we're gonna get into pricing tomorrow. And I think pricing is very important, and I don't think you should ever trade an option contract until you have the basics of pricing.
I'm gonna do it in very layman's terms tomorrow when we get into the pricing section. But that time value is very important. And we'll talk all about how probability works into it. We'll talk about volatility and another word in the insurance world, that would be risk. In the options world we call that volatility.
We're gonna talk about those things. So this is a great preference to come in tomorrow, Rudy. Or Ruby, there's not a D that's a B, Ruby.
Overall, you've really foreshadowed what tomorrow's seminar is all about. Joseph says, can you explain the break even point price? Okay, so that's also gonna happen tomorrow, but let's go back to our example. Let's go a page up. Okay. Yeah, strike price.
Okay, so right here, let's do stock ABC. XYZ, stock XYZ is a Call option, that'll be easy. Trading for $3.10.
Let's say the stock was trading at about 70. So that would be an At-The-Money option contract. If we learned something today, that's what we learned, an At-The-Money option contract. If I want to know what the break even is, I have to realize I have the right to buy the stock at 70. I have to pay $3.10 for that right. That's basiCally going out to the January expiration.
This is all time that I'm paying because the stocks at 70, just making a fictitious example to go along with fictitious stock XYZ. Well, how far does it have to go to break even? Well, I'm paying $3.10, right? Stock's at 70, strike 70, you have the right to buy it at 70. I need it to get to 73.10. That's where I break even.
So if I hold this all the way to expiration and all the time value has gone away, and the stock is still trading at 70, guess what? I paid $3.10 cents for it. And I'm not gonna get that back. Why? Because if the stocks at 70 and the strike of 70, there's no value in this option contract. I need it to go to at least $3.10 in that scenario, and that would be where the break even is that.
I mean, how often, if you think once again of the insurance world, do you drive your Bentley around for a while and the six month policy expires and you say to your insurance agent, oh, I didn't crash my car, will you give me my premium back? Overall, no, it doesn't happen. So the moral of the story here is that if you think of options from where they came from, it's much easier to understand why they're priced the way they are, why they're a contract overall, and everything else that goes along with options and where they came from. As a matter of fact, I just pulled out this book. I haven't seen it in a while, because I haven't been in the office that much lately.
But Herbert Filer actually, as far as I'm concerned, as far as I know, this is the first book that's ever written on options contracts. I do happen to have a copy. If I'm wrong about that, somebody else can tell me, because I've never seen a book that's any older than this. And it was actually copyrighted in 1959.
And it actually says the author has more than 46 years of active experience. So that implies how long option contracts have been around overall. And what's kind of fun about it is it does actually have like advertisements for option contracts overall. So there's a lot of little neat nuances to the history of options in that book overall. So I just thought that was kind of fun. I thought I'd grab it as a little prop to let you know that option trading has been going on long before the Chicago Board Option Exchange ever opened their doors and first started trading listed options.
So you guys are kind of preferencing the two questions that I have, but The Magnificent is back again. How can a Call's exercise price be priced less than the current trading price of a stock? Very easily. I think the chains might have answered that. You're going to have strike prices that are going to be set. The stock is going to move In and Out-Of-The-Money. You don't go into the marketplace and say, right at this moment, I am going to buy an At-The-Money option contract, please make up this exact contract so that I can trade it.
No, there's... Stocks move. You got to set up contracts. And when one set of option contracts expire, there are new contracts that are written. And that goes all the way back to this one question.
So right here, there's my question. Sorry to flip through it that fast. But if nobody buys or sells an option contract that is being quoted, does it really exist? And the answer is, it doesn't. Markets can go out and quote options all they want. Geico, All State, all these insurance companies can say, oh, please, we have the lowest rates that are out there as far as your car insurance is concerned. Please come in and open up a contract with us where we can write that contract and sell you that policy.
Well, if all that advertising fails and nobody goes to open up a contract overall, then that contract never exists. Same thing in the options world. It's all about the fact that it is a contract. And if nobody buys it and nobody sells it, then the contract really doesn't exist overall. It can be quoted, that's the advertisement, but until somebody trades it, the contract does not exist.
And that gets into volume and open interest. And that's gonna be a big theme tomorrow. We talked about liquidity. Liquidity does matter. And there are instances, like people might want to trade stocks on Consolidated Widgets, a made up company, trade options. But it might be who view to not trade them because the markets are not liquid enough.
Why? Because the underlying stock isn't, and it's kind of like kind of crazy why they even trade options on some of those underlines. At one point in time, it was the hot company and now it's not anymore. That happens more often than you'd like to think too. And then if I buy a Call, do I have to buy the stock at some point? The answer, I'm just gonna be blunt since we're past time right now.
No, you don't, you don't. And as a matter of fact, it's more common to buy an option contract and sell it at a later date than it is to come on out and buy that option contract and exercise it. And that's foreshadowing for tomorrow. All right. One question from Elizabeth.
Oh, that was it. That was actually it. Elizabeth, I just addressed your question. Do you have to buy the stock in order to buy the option contracts? And I just answered that, Elizabeth. Please come tomorrow. We'll get into more detail, click subscribe, ring the bell.
Let us know if you like what you're hearing. Anything else that you'd like us to try to cover, I really want to make these interactive sessions. I have not done a very, very basic option seminar in many years, basically going all the way back to when I used to work for the Chicago Board Option Exchange, actually. So go to, to sign up for all the events, I'm gonna show my screen here. Ally.com/investeducation.
Follow me on Twitter. Checkout optionsplaybook.com. If you want to read up, that's great reading on the website. Pull it up on your phone before you go to bed tonight and read a little bit about option contracts.
Overall, it might help you sleep. All right. My name is Brian Overby, senior options analyst with Ally Invest. Thanks for coming. Please share our registration page with everyone and we'll see you tomorrow, 2:30 PM. Eastern time.
2021-12-04 00:10
