A big, little primer on options

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A big, little primer on options

What’s an option, you ask?

Let’s start with the simple definition: a “stock option” is a contract to buy or sell a particular stock at a specified price for a limited period of time.

Now, in human speak: think of an option like a mini version of the stock that it’s attached to—it’s tradable and some of its value is tied directly to the stock itself.

And like stocks, options also trade in an auction style market—meaning they have an “ask” (the price you can buy it) and a “bid” (the price you can sell it). Like stocks, you can make or lose money on the options you trade as prices change.

But that’s where the similarities begin and end. Options have many nuances which we’ll cover both here and in other articles. Not to mention, for any one particular stock there could be thousands of different options. "Why," you ask?

Well, there are two kinds of options—“call” and “put” contracts. Calls (aka call options) lock in a price to buy stock. Puts (aka put options) lock in a selling price. Calls and puts move in opposite directions, kind of like traffic on a two-way street. You can buy calls when you think the stock will go up, or buy puts when you think it’ll go down.

Just like the milk in your fridge, options expire. Some expire in a day or a week, while others expire in a month, many months, or even years. But, option contracts don’t have to be held all the way to expiration. In fact, most options traders close their position before it reaches its expiration date.

Look at these option chains of calls (left) and puts (right) of the hypothetical company, Tiger, Inc. (Stock symbol MEOW).

It’s important to know that there are many “strike prices.” Since options are contracts, “call strikes” lock in a buy-price of the stock and “put strikes” lock-in the sell-price of a stock. There are many strikes above and below the price of the underlying stock—the further away from the stock price, the more expensive or cheaper the options get depending on whether they are “in the money” or “out of the money.”

The “in, at, and out of money” options

Even though there are a ton of different strikes, you’ll hear traders referring to three groups: “in the money” (ITM), “at the money” (ATM), and “out of the money” (OTM) options.

In the money: options with strike prices that would give you the right to trade the stock at a better price than the current price of the stock.

  • For calls, it’s the options with strike prices that are lower than the stock price.
  • For puts, it’s options with strike prices that are higher than the stock price.

At the money: options with a strike price that’s either right at (or very close to) the stock price. This can include the nearest ITM and OTM options since the stock is rarely exactly at the money.

Out of the money: options with strike prices that would give you the right to trade the stock at a worse price than the current price of the stock.

  • For calls, it’s the options with strike prices that are higher than the stock price.
  • For puts, it’s options with strike prices that are lower than the stock price.

There’s nothing inherently good or bad about any of these types. What’s important to note is the difference in which their prices change as the stock moves. The very deep ITM options (calls with very low strike prices, or puts with very high strike prices) may change nearly dollar-for-dollar with the stock. The super far OTM options (calls with very high strike prices, or puts with very low strike prices) will move slowly (if even at all). The rest of the options will change price on a continuum between the two extremes (think of a slope that is gradually changing), with the ATM options changing price at about 50% of the change in the stock price.

Even though option prices don’t change as quickly as the stock does in dollar terms, the percentage change in an option’s price can be huge. But option prices can also go to zero, whereas that’s tough to do with the stock of a major company (although, it can happen, too).

Why consider buying calls?

Because you think the stock that it’s attached to (the “underlying” stock) is going up. Period.

Here’s an example (stay with us—we’ll explain each piece). Let’s go back to our theoretical company, Tiger, Inc. Its stock (ticker symbol MEOW) is trading at $128, and you pay $2 to buy one MEOW January 29th 140 call option. January 29th is the expiration date, and 140 is the strike price. The $2 price you paid is called the “premium” and it’s the price per share. Since each option controls 100 shares of stock, your cost to buy this call is actually $200. Compare that to shelling out $12,800 to actually buying 100 shares of MEOW.

Why would you buy a call option that gives you the right to lock in a buying price that’s $12 higher than the current price $128? Because there’s a chance it could get there before expiration. As an options trader, you don’t really care if it does get there, but the price of the option reflects that probability. If there’s a chance that the stock could be above the strike price at expiration, then the option will have value. That probability increases when the stock goes up, which is what drives the option price higher. And that’s how profits are made— you don’t need the stock to reach the strike price in order to have a profitable trade, but it certainly helps.

But here’s the rub: even if MEOW goes higher, it might not be enough to profit because it took too long to get there. The key here? Time. Time is also a factor and is the arch nemesis of long options traders because time erodes options premiums. Let’s say that again: time erodes options premiums. If MEOW is below $140 at expiration, the option goes poof— and it ain’t worth a penny. At $142, you breakeven. But again, you do not need, nor likely want, to hold the option that long, since the stock doesn’t need to reach the strike price in order for you to profit.

On the other hand, assume that MEOW jumps to $150. A call option that has a strike price that’s lower than the current stock price is said to be “in the money.” A call with a 140 strike price is worth at least $10 ($1,000 per option). That’s an $8 profit on a $2 trade, which is a 400% return, and it might be smart to close the trade in this situation.

But what if you still own this call and it expires in the money (remember, in the money is when a call option has a strike price that’s lower than the current stock price)? This is the only time you would be forced to exercise your call to capture its value, and if you don’t want to be on the hook to buy $14,000 worth of stock (for each call you own), you need to sell the option before it expires.

What about puts?

“Put options” work very much the same, except in the opposite direction. If you think a stock is going down, you can buy “puts.” Whereas calls let you lock into a buy price, buying a put option gives you the right to lock-in a selling price for the stock. This means that put options usually increase in value when the stock moves lower.

Buying puts is a less risky way to root for a stock’s tumble than shorting a stock because you can only lose what you pay for the put, whereas the risk of loss when shorting stocks is unlimited (remember, shorting stock isn’t actually allowed on Robinhood).

Let’s go back to the example of MEOW, which is trading at $128. Suppose you buy the February 19th 120 put for $3.00 because you think MEOW is moving lower. You’ve got a maximum risk of the $300 you paid for the option. If MEOW moves lower between now and expiration, the 120 put could increase in price, and you could sell your put option for a profit. Or, worst case scenario, the option loses all of its value and you’re out the $300.

The big three of options pricing

Despite what it may look like, there is a method behind the madness of option pricing—it isn’t arbitrary. The good news is that all the heavy math has already been done for you when you see a price quote. But since we’re here, let’s geek out a little and break it down a bit.

The three biggest influences on option prices are:

  • Price - stock price compared to strike price
  • Time - number of calendar days until expiration
  • Implied Volatility – how much the stock is expected to move in a given timeframe

There are others, such as interest rates, and dividends, but they don’t have as much of a material impact. For now, let’s focus on the big three.

Stock price vs. strike price: comparing the stock price to the strike price determines if the option has any “real value.” Real value (also commonly referred to as Intrinsic Value) is the amount that an option is in the money (remember, we can also shorten this to ITM). If a call option is already $5 ITM, you’re not getting that for free. That $5 will be baked into the option price and that ITM amount is called the “real value” of the option. ATM and OTM options don’t have any real value. All option prices have another component which is the “time value”—composed of time itself and “implied volatility.”

Days until expiration: the more time there is until expiration, the more time there is for the stock to move. This means there’s more time for the option to move ITM (or OTM for that matter). The more time, the more expensive the option. No complex formula on this one—it is that simple. When you look at the same strike price across expiration periods, you’ll see that options get more expensive with longer time frames.

Implied Volatility: a big part of expressing the cost of an option’s premium is in the implied volatility (IV), which is an expression of how much the stock is expected to move as a percentage. The more a stock is expected to move, the greater the time value component is going to be. This is where “implied volatility” comes in. An option with low IV will be cheaper than the same option with high IV. In practical terms, it’s a way of expressing the “relative” cost of an option.

The clock is always ticking

Looking at options across all expiration cycles, the lower priced options (relatively speaking) are those that expire first. Just because something is lower in price doesn’t necessarily make it better—they’re cheaper for a reason. Based on all the other inputs of an options price, including volatility, time, and stock price, a “cheap” OTM option has a low probability of ending up ITM by expiration. This is in part because a stock’s move higher might not be fast or far enough to offset something called “time decay,” or the cost of holding an option per day (in trader geek-speak, this is called “theta”).

Time decay can happen slowly (in the case of longer-term options) or very quickly (short-term options). Let’s take a look at this graph:

Notice that the time decay of a: 90-day option barely registers—the line looks relatively flat and there’s little change. 60-day option picks up steam and starts to have a material impact on the option premium. 30-day option that is headed into expiration is often greater than the impact of the stock price moving higher.

Add to that a drop in IV (implied volatility), and a lower priced OTM option will likely get crushed—a numbing frustration to option traders all over. To trade short-term options, you have a much smaller window of time for the stock to move higher, whereas, buying longer-term options, you have some breathing room should the stock stall or take its sweet time moving higher.

When it comes to options, there’s a lot to unpack. Take your time and get to know the ins and outs of calls and puts before you jump in. Once you understand the basics, you can start to grasp and see the bigger picture. Once you’ve mastered calls and puts, you can then begin to piece different options together across price, strikes, time, and volatility to accomplish seemingly endless possibilities to trade up, down, sideways, and dunno markets.

Next up: Let’s talk about volatility

Disclosures:

Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.

Content is provided for informational purposes only, does not constitute tax or investment advice, and is not a recommendation for any security or trading strategy. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Robinhood Financial does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.

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