What is an Option?
An option gives the owner the right to buy or sell a certain security, at a certain price, up until a certain expiration date.
An option is a contract that gives the owner the right — but not the obligation — to do something. It’s a “derivative,” which in finance is something whose value is dependent on the value of something else. An option’s value is dependent on the price of the underlying security it’s linked to, like a stock. An options contract allows the owner to buy (in the case of a “call”) or sell (in the case of a “put”) 100 shares of the underlying asset. It only makes sense to exercise the option if the price of the underlying stock is on the right side of the strike price, aka if the option is “in the money.” If you own a valuable option, you may be able to exercise it, or sell the same option you bought to another investor (aka closing your position), for a gain. Options often expire with no value, so you should understand the risk before investing.
On July 15, 2019, Uber’s stock was trading at $44. If you’re bullish on Uber and think the stock will rise, you could have bought a call with an exercise price of $48 that expires Jan 17, 2020 (that was available on the Robinhood investing app on that day). That option cost $3.40, and since it gives you the right to buy 100 shares of Uber for $48 any time before January 17, 2020, it cost $340 (plus fees and commissions). That premium is your cost, and you hope that Uber’s price rises above $48. If it does, you could make a gain. If the price increases to $55 (for example), you could exercise the option, buying 100 shares for $48 each even though they’re worth $55 (you’d make some money!). If the stock stays below $48 through the expiration, that option won’t have any value for you and you’ll lose the $340.
An option is like an umbrella... It could be valuable for you, or it could end up having no value at all. The beauty with an option, and with an umbrella, is that you don’t have to use it. You bought it, now it’s your option whether to exercise it or not. You use the umbrella when it rains. You exercise the option if it’s in the money. Options expire though, umbrella’s don’t (no analogy is perfect).
An option is actually a legally-binding contract – it ties the buyer and the seller of the option to do certain things. The buyer gets the right to buy or sell, per the option contract, and since there’s value for that, she pays the seller a premium. The seller has made a promise to buy or sell the stock at a certain price, until a certain expiration date, if the buyer exercises it.
Here’s some vocab you should know.
There are two types of options: a call and a put.
If you have a coupon to buy a Big Mac for $20, that’s pretty much a worthless coupon — you’ll just throw away the coupon and buy a Big Mac for the normal price (which is less than $20, last time we checked).
Options are like coupons in the sense that you don’t need to use them, but you can if it makes sense based on the price of the underlying thing (like the Big Mac, or a stock). Whether an option has value depends on what the underlying asset price is compared to the strike price.
Options can be in the money, at the money, or out of the money.
For a call, the value of the option generally increases as the price of the underlying asset increases.
For a put, the value of the option generally increases as the price of the underlying asset decreases.
An option’s value is reflected by its price, known in the business as the “premium.” As a retail investor, you just see the price of the option as a number shown on your brokerage platform. But it really has two chunks:
Intrinsic value + Time value = Price of option
Ultimately, options may be valuable for the likelihood that they become in the money. If they’re in the money already, they have intrinsic value. Time value exists because more time increases the chance that the underlying asset price moves and makes the option become in the money.
And the value of an option is reflected by its premium price.
The owner of an option has the right to exercise the contract, let it expire worthless, or sell it back into the market before the expiration. The owner of the contract is likely to exercise the contract if it’s “in the money.” On the other hand, the seller of an option contract who collected a premium has the obligation to buy or sell if the option owner exercises it.
If you own an option, there are three things you can do:
There are two key investing options using options for investors who are bearish, and for investors who are bullish.
If you’re bullish, you think a stock price will go up. To act on the optimism, you could buy a stock, or you could invest in options. Here are two bullish options strategies:
If you’re bearish, you think a stock price will go down. To make an investment based off of your pessimism about a company’s prospects, you could short a stock, or you could invest in options.
When it comes to options, you can be the buyer or the seller.
As the buyer of an option, your risk is limited to just the premium that you paid. The worst case is that the option expires out of the money, worthless, and you lose the entire amount you paid for the option. The best case is that the option moves into the money and you make a gain that makes up for the premium you paid.
As the seller of an option, your risk is more open-ended. If you sell a contract, you’re hoping that it never gets exercised. In that case, your gain is the amount of the premium. If it does get exercised, you could be on the hook to buy or sell a stock at a money-losing price.
It’s important to understand that as the seller of an option, your risk is potentially unlimited. As a buyer, your risk is that your option expires with no value, and you lose the entire premium you paid with nothing to show for it.
Options transactions may involve a high degree of risk. Please review the options disclosure document titled Characteristics and Risks of Standardized Options available here to learn more about the risks associated with options trading.
Options are available to retail investors through brokerage companies, like Robinhood.
You buy an option for a premium. The cost to you is the premium (remember that premiums are often quoted as a per-share price, but are sold in contracts of 100 shares. So a $0.30 premium would cost $30, since it’s good for the right to buy or sell 100 shares of the underlying asset) plus any commissions and fees your brokerage charges. Note: Robinhood does not charge commissions (Other relevant SEC and FINRA or other fees may still apply. Please see Robinhood’s Commission & Fee Schedule here) .
What is the Cost of Goods Sold?
Cost of Goods Sold (COGS), is how much a company spends to directly create a product or service – The calculation? Beginning Inventory + Purchases During the Period - Ending Inventory.
What is a Fund?
A fund is a pool of money dedicated to saving, investing, or virtually any other purpose either by an individual, a business, a government, or any other type of entity.
What is a PE Ratio?
The price-to-earnings ratio (P/E ratio) measures how “expensive” a stock is by comparing its stock price to its earnings per share.
What is a Strike Price?
An option is a contract guaranteeing the buyer of the option the right to buy (in the case of a call option) or sell (in the case of a put option) an asset at a predetermined price — and that predetermined price is called the strike price.
What is Profit Margin?
Profit margin measures how many cents of profit a company keeps for every dollar it spends.
What is a Broker?
A broker is a person or a brokerage firm that usually charges a commission (a fee) for matching investors who want to buy or sell securities (like stocks or bonds) with the other side of the transaction. (Robinhood Financial LLC is a brokerage firm, and doesn’t charge buyers or sellers a commission for executing orders.)