Options contracts explained | Greeks, Implied Volatility, Strike Prices, Expiration Date
What if I told you that you can have the capital appreciation of a growth/value portfolio, and the income of a dividend portfolio? Well with options you can do just that!
This is just one of the reasons why I find options fascinating and underutilized by the average long term investor.
This video is all about options contracts. What they are, how they change, what they do, and how we can make money trading them.
I will describe everything you need to know in order to master the basics of options.
I consistently make between $500-$1000 per month selling options on high quality companies with no more risk than just buying shares. And you can too! Watching this video is the first step of learning how to do it!
Options are used in order to take a leveraged position in an underlying stock, but the intent behind taking the position isn’t always the same. One option contract could be a bullish position and at the same time a bearish position depending on how you enter the position.
In the next series of videos I am going to take a step back and talk about the basic mechanics of options and how anyone can use them to increase their returns in the market. So make sure you are subscribed to the channel to get notified when the next videos come out! I’m trying to get to 1,000 subscribers by the end of the year so I would really appreciate it!
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Let’s start with the fundamental structure of options contracts.
An options contract is an agreement between two parties to represent a potential transaction involving 100 shares of a stock at a preset price within a period of time.
At the root of an options contract, it is a means of exchanging 100 shares of a stock or etf.
Think of it as an agreement between two people to exchange 100 shares of a stock, should certain criteria be met (which we will get to later in the video).
Another way to think about it is through the eyes of leverage. An option contract is a means of controlling 100 shares (long or short) for a significantly lower amount of capital.
There are two types of options: Calls and Puts
Call Options allow the buyer to purchase 100 shares at a specific price within a specified period of time.
Call Option sellers have the obligation to sell 100 shares of a stock should the buyer exercise the contract on or before expiration day.
Put Options allow the buyer to sell 100 shares at a specific price within a specified period of time.
Put Option sellers have the obligation to buy 100 shares of a stock should the buyer exercise the contract on or before expiration day.
Think about it this way.
A buyer of a call option wants the shares of a stock, so they CALL to the seller of the contract to give them the shares. “Hey you! Give me your shares.”
On the other hand a buyer of a put option wants to get rid of their shares of a stock, so they PUT their shares with someone else. “Here you take these shares, I don’t want them anymore.”
My strategy and personality tend to align with that of an Option Seller. I rarely buy options.
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Options contracts have 3 basic components:
The expiration date, The strike price, and the premium.
The expiration date designates the time period for which the contract is valid. The strike price designates the price in which the underlying shares of the contract are exchanged. The premium is how much the contracts are bought and sold for.
A good rule of thumb I like to use when buying options is to make sure the expiration date is at least 6 months in the future, if not 12–24 months in the future.
These long dated contracts are often referred to as LEAPS. Long Term Equity AnticiPation Securities. The reason I prefer to buy long dated options is because they give you a long time frame to be right, and they decay significantly slower than short term options.
When selling options I like to use short term options typically between 30–60 days to expirations. By selling options with short expiration dates you take advantage of the mechanics of options and the natural decaying properties.
In short, when buying options I go for 6 months or longer expirations. When selling options I go for shorter term 30–60day expirations. I will talk about why more in depth in dedicated videos coming up, so make sure you’re subscribed so you don’t miss it!
When picking the strike price of an option contract there are important things to know about the moneyness of the contract. Specifically the terms Out of the Money, At the money, and In the money.
At the money contracts are options contracts that have the closest strike price to the actual market price of the underlying stock. If the stock is trading at $143.43 like Apple is in this example. The $143 strike and $144 strike are the “At the money” strike prices.
The “out of the money” strike prices depend on if we are talking about call options or put options.
For call options, “Out of the money” call contracts are those where the strike price is above the current market price. In this Apple example all of the strike prices above $144 are considered out of the money contracts.
For put options, “Out of the money” put contracts are those where the strike price is below the current market price. In this Apple example all of the strike prices below $143 are considered out of the money contracts.
Out of the money basically means: If the option were to expire right now, the option would be worthless because the current market price provides a better opportunity.
For example with an out of the money put option (we know that put options are used to sell 100 shares at a specific price). If we own a $137 apple put option that is expiring today, this contract would be worthless because it makes more sense to sell our apple shares at the market value $143.43 instead of through our put options which lets us sell at $137.
The same will hold true with out of the money call options.
On the other hand “In the money” contracts are the opposite of “out of the money” contracts.
For put options, in the money puts are those where the strike price is greater than the current market price.
For call options, in the money calls are those where the strike price is less than the current market price.
In the money contracts hold what is called “intrinsic value” because at expiration they are worth the difference between the market price and the strike price and will not expire worthless. Out of the money contracts are completely made of extrinsic value, which is value derived from the uncertainty of future price and time.
Both of these concepts of Intrinsic vs Extrinsic value, I will go deeper on in another video, but now we know the basic difference between at the money, in the money, and out of the money contracts.
For me when selling options I only sell at the money or out of the money contracts. When buying options (which rarely do) I prefer to purchase in the money options. (options with intrinsic value)
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The final piece of the options contract is the “Option’s Premium”. This is the price we actually buy and sell the contracts for. You can see the current premium for each option contract by looking at the bid and ask columns in the apple example.
Let’s say for example I want to purchase an apple call option with the $140 strike price. I would pay somewhere between the bid and ask spread. Likely right about $6.00. Since an option contract represents 100 shares I would actually have to pay $600 because $6.00 per share x 100 = $600.
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So how do I make money with options? I am going to give you a high-level overview of how you make money with options. Then in future videos I will dive deep into some strategies that will show us exactly how we can take action and make money. For now, just a birds eye view.
You either fall into 1 of 2 camps with options. Buyers or Sellers.
Let’s look at how you make money as a buyer.
Options have a set of properties that describe how they behave based on the underlying stocks price movement. They are known as “the greeks”
Here it is very important to understand one of the greeks. Delta. The options delta value describes how the price of an option changes for every $1 move in the underlying stock. There are a few things in addition to delta that go into options pricing and price change, but for now this is all we need to know.
When you buy a call option your contract increases in value when the underlying stock moves up based on the options delta value. If an option has a delta of .55 like this Apple call option, this means for every $1 apple’s stock price increases this call option will increase by $0.55. With call options you make a leverage return when the stock goes up.
When you buy a put option your contract increases in value when the underlying stock moves down based on the options delta value. If an option has a delta of .58 like this Apple put option, this means for every $1 apple’s stock price decreases this put option will increase by $0.58. With put options you make a leverage return when the stock goes down.
I typically don’t buy options, but as part of my investing strategy I frequently sell options every month to generate income from my portfolio. Describing option selling is a slightly more complex topic because the mechanics of it don’t necessarily have to do with price movement. I have already made some videos on option selling but I will be making dedicated videos in the future that I will link in the video description so make sure you are subscribed to my channel to not miss out on the future videos.
If you’ve made it this far in the video, know that I appreciate you and hope you learned something today about option contracts. Remember to Stay Bullish and I’ll see ya in the next video. peace
