Vinyanyérë wrote:RefluxSemantic wrote:Vinyanyérë wrote:Found myself explaining how options work to three completely unrelated people in the last 48 hours so that's probably a sign of something, not sure what yet.
explain it to me too
Alright so let's say you think is a stock is going to go up. So you find somebody and you make a deal with them - you get the choice to buy the stock from them at an agreed-upon price (called the strike price) at a future date. This is called a call option. If the stock goes up above that agreed-upon price, you go ahead and buy it from them, at which point you can hold onto the stock or immediately sell it back on the market. Since the stock is above the price that the other party agreed to sell it you at, you make a profit on that stock sale. If the stock doesn't go above that price, you can still buy the stock from them if you want to, but you have no reason to - you can just buy it on the market instead for less.
Now the person you're making a contract with is also trying to make money, so they're going to add two stipulations. Firstly, you'll have to pay them some amount of money to get the choice to buy the stock - if you didn't have to pay anything, you'd just make these contracts with everyone possible on every stock expecting one of these stocks to go up, and obviously nobody would take that deal. So the person selling this contract is getting some money from you (called the premium). Secondly, there's a time limit to this contract, after which point the contract is no longer valid. Otherwise you'd buy a bunch of contracts and wait an infinite amount of time for the stocks to go up.
For you to make money, the stock has to go above the strike price plus the premium by the expiration date. The person selling you the contract is expecting that not to happen*.
Now in practice if the stock goes up beyond the price at which you'd profit, you wouldn't actually exercise the contract and make the other party sell you the shares. You'd just sell the contract back on the market for a profit. That's because the contract itself has value, with the idea being that on the expiry date, if the stock price is higher than the strike price, whoever happens to have the contract could exercise it and buy the shares from the person selling the contract. As a result, the value of the contract should at least be the current value of the stock minus the strike of the contract (minimum $0). That value of the contract is the same as the aforementioned premium - when the contract is first written by the seller, they're setting the premium that the buyer must pay at the value of the contract. After the contract is written, however, it can be traded on the market basically just like a regular stock, with whoever owns it gaining the right to exercise it from the person selling it.
The value of the option stems from the price of the stock itself (the underlying), but also comes from the strike price (which doesn't have to be the current price of the stock) and the time until expiration. Basic intuition - the higher the strike price, the cheaper the premium, because you're agreeing to buy the stock at a higher price and thus it's less likely the stock will go above that price. And the less time to expiration, the less uncertainty there is in the stock price, so the cheaper it is. The strike is set at the beginning when the contract is written - after that, the option's value is determined by the underlying and the time to expiration**. If the underlying stays flat, the option loses value over time. If the underlying goes up, the option goes up, at which point it can be sold at a higher price. If the underlying goes down, the option goes down, and if the underlying stays down, the contract eventually expires worthless. The actual exercising of the contract is not too interesting for individual investors, likely some server in New York is the one that exercises it in the end to scrape out the last few pennies of value.
That was (long) call options. Next is long puts, after which we can go to short calls and short puts, and from there we can get to the really good stuff.
The practical benefit of calls, by the way, is that they're a way to amplify gains and losses. Quick real world example - Twitter right now is trading at $48 a share. I could buy a call on Twitter with a strike of $48 expiring Jan 29 for $1.30 (I do not recommend this). The delta on this option is 0.52, meaning that if Twitter goes up in price by $1 and everything else is held constant, the value of the option goes up by $0.52. If I bought a share of Twitter at $48 and it went to $49, that's a 2% profit. If I buy this call of Twitter and Twitter moves from $48 to $49, that's 40% profit. The risk is that if Twitter goes down or stays the same and I own the stock, it's going to cost a lot less than if I had bought a call, unless Twitter goes down substantially.
I'll go over puts later and talk about short calls. So in order for you to buy a call, someone else has to be selling it, right? You might think all the calls get sold by some big institution, but you're allowed to write them too. If you buy a call, it's a long position. If you sell one, it's a short one. Now when you sell a call, you're predicting that the stock will stay flat or go down*. Let's take Twitter again - you sell me the call at $1.30 for a $48 strike. If on Friday, Twitter is less than $48, I don't exercise and you walk away with an extra $1.30. But let's say that instead, Twitter goes up to $50. Now I do exercise the call, and so you're obligated to sell me a share of Twitter at $48 (aside: most options are actually done in multiples of 100 shares, so realistically you'd have sold me this call for $130, and be obligated to sell me 100 shares of Twitter at $48 a share, or $4,800. But this doesn't really matter).
If you don't have that share of Twitter available, then you have to go buy it on the market - in this case, at $50. You sold the call for $1.30, bought a share of Twitter at $50, and sold it for $48, meaning you made $1.30 and lost $2 for a net loss of $0.70. Not the end of the world. Let's say Twitter really pops over the next week though - maybe it goes to $500. You're obligated to sell me the share at $48, so suddenly you're on the hook for $452.
Because selling calls like this can lose you theoretically infinite amounts of money, a lot of platforms won't let you do this. What they will let you do though is sell covered calls, where you buy the stock and then sell a call against your own position. This is where the asterisk comes in. Let's return to Twitter and suppose that you buy a share of Twitter at $48, and then sell the January 29 call with a $50 strike, currently going for $0.59. If January 29 arrives and Twitter is below $50, the call won't be exercised and you made $0.59 + (current price of Twitter - $48). If Twitter is above $48, you can go ahead and sell Twitter at a profit and get some extra profit on the call you sold. If Twitter is below $48, you can sell it at a loss if you want to put your capital elsewhere (thus, your sold call will mitigate or eliminate your losses), or you can keep the stock.
This is where the fun begins. If Twitter goes above $50, the call is exercised and you sell it at $50. But you bought it at $48, so you sell it at a $2 profit and still get the money from the call you sold, effectively getting $2.59. If Twitter doesn't go above $50, the call expires worthless, you get $0.59, and you still have the share of Twitter. You can take that share of Twitter and sell another call against it the next week, getting a little bit of extra premium on it. You can keep doing this until the call is exercised on you for a profit or you sell your share of Twitter.
In essence, you would sell calls on stocks that you own that you think will be relatively flat. You wouldn't do this on a stock that you think is going to go up a lot, because then selling a call would cut into your own profits. You also wouldn't do this on a stock that you think is going to go down a lot, because then you don't want to own the stock in the first place. But if you think the stock is going to be relatively stable and climb in a predictable way, you can own the stock and sell the calls against it to make extra money. It's not riskier (in terms of getting blown out) than owning stocks regularly, at the cost of losing upside if the stock makes a big run.
Join me tomorrow where I talk about long and short puts, which will give us enough knowledge to talk about "The Wheel".