In Options for Beginners Part 1, you learned that options can be relatively safe, profitable trading strategies for new investors. Now let’s answer the question, “What are options?”
What Are Options?
Options are another form of investment that can be bought and sold just like stocks, bonds, or commodities.
But rather than investing in company ownership like stocks, options are contracts, promises to buy or sell a specified stock by a specific date.
This is what’s referred to as “derivative” investments.
When you buy or sell an option, you don’t own anything. You’re entering into a contract with someone else to either sell them your stock or buy their stock from them.
Also, each option contract is for 100 shares. So if a contract is fulfilled or “exercised,” someone is always buying 100 shares from someone else.
There are 4 important elements to an options contract:
- Underlying Stock
- Strike price
- Expiry date
- Premium
Underlying Stock
If I promise to sell you my XYZ stock at $107 per share by February 18th 2024, the “underlying stock” in this contract is XYZ. Many ETFs have option contracts on them as well, like SPY, QQQ, VTI, IWM, etc.
Strike Price
In the example above, the “strike price” is $107 per share. So contractually, you have the right to “exercise” our contract and buy the shares at $107 at any time. You’re not obligated to buy the shares, but you have the right to.
Expiry Date
Every option contract has a time limit. In the example above, the “expiry date” is February 18th, 2024. You can have expiry dates of anything between one day to three or four years out in time.
Premium
This is where things get interesting. The buyer of the option contract pays a small premium to the seller up front. So in our example above, as the seller, I’m making the promise and have an obligation to you. You have to pay me a small premium to take on that obligation. Let’s say the premium is $0.50 per share, because every option contract is 100 shares, you would pay me $50 up front.
I’m sure these definitions are stirring up countless questions. Let’s continue one step at a time. First let’s look at the two types of option contracts: calls and puts.
Call Options for Beginners
The buyer of a call option wants the right to buy 100 shares of XYZ stock if it reaches $XX per share by XXXX date. For that right, they pay the seller a small premium of $X.XX per share.
You can both buy or sell calls.
On the other side of the transaction, as the seller of a call, you’re promising to sell shares you already own. For that promise, you collect a small sum up front.
This is technically known as a “covered call,” because your promise is covered by the shares you own. Let’s look at an example…
Covered Call option example: You sell a call contract that promises you will sell 100 XYZ shares for $107 per share until February 18th, 2024 if the buyer decides that’s what they want.
Of course, you should own 100 shares of XYZ if you’re going to make that promise.
The call buyer pays you a premium (cash) upfront for that promise, for the right to buy XYZ shares from you.
TIP: Generally you want to set your strike price above the average price you paid for your stock. That way you profit off this trade.
It’s like the buyer is paying you to put those shares aside for them for a specified period of time. Whenever they want, they can buy your shares for the price specified in the contract (the strike price).
As the seller of the call contract, you are obligated to sell your share at the strike price until the expiry date. Now, you only have to sell your shares if the buyer “exercises” the contract (enforces their right to buy).
The buyer doesn’t have to exercise the contract, though, in which case you get to keep the premium and don’t have to sell your stock.
NOTE: These strategies are part of what we call “Stock Hacking.” It can be a solid side hustle if you know what you’re doing!
Put Options for Beginners
The buyer of a put option wants the right to sell 100 shares of XYZ stock if it reaches $XX per share by XXXX date. For that right, they pay the seller a small premium of $X.XX per share.
You can both buy or sell puts.
On the other side of that transaction, as the seller of a put, you promise to buy shares of a stock. For that promise, you collect a small premium up front.
Technically this is known as a “naked put.” Let’s look at an example…
Naked Put Option Example: You sell a put contract that promises you will buy 100 shares of XYZ for $93 until July 15th, 2024, if that’s what the buyer wants.
The put buyer pays you a premium (cash) upfront for that promise, for the right to sell XYZ shares to you.
TIP: Generally, you want to set your strike price below the current price of the stock. That way, if the stock drops, you have a buffer before it reaches your strike price.
This is insurance for the put buyer. They know they can sell their shares at the price you agreed to until the contract expires.
As the seller of the put, you are obligated to buy the stock at the strike price until the expiry date. You only have to buy the stock if the buyer of the put contract “exercises” the contract (enforces their right to sell).
The put contract could expire without any action being taken by the buyer, in which case you keep the premium and don’t have to buy the stock.
I still don’t get it…
Don’t worry. This is a lot to wrap your head around at first.
To keep things simple, we’re going to assume that we’re the option sellers. That way we can collect cash up front and we can create a buffer for error, in case the stock price doesn’t move in our direction.
So for now, remember this:
Selling a covered call is a promise to sell your shares.
Selling a naked put is a promise to buy someone else’s shares.
In Options for Beginners Part 3, we’ll dive into more examples so you can get a better idea of how this all works.
What am I supposed to do with this info?
There’s so much to learn about stock options. The examples above are only a couple ways for beginners to start trading options.
So for now keep learning. Subscribe to our newsletter if you want to get weekly stock option education emailed directly to you. That link will actually let you sign up to download a FREE case study we compiled call “The Ultimate Side Hustle for Canadians.”
And we’ll talk to you later!
Happy trading,
Erwin and Cherry Szeto
P.S. If you’re interested in finding a new side hustle, we’ve put together a new case study that examines the four most popular side hustles for passive income in Canada. You can download this case study for FREE right now if you sign up for our email newsletter.
