Have you ever felt like options trading was a puzzle you just couldn't crack? I know the feeling all too well. So once I figured out how these complicated trades work, I employed my teaching expertise to demystify option trading for others, making the information more accessible than it initially was for me.
But then, as happens to all open-minded educators, my students became my teachers.
Just when I thought I had explained it all clearly with my 4-square chart, questions from a couple of my 1:1 coaching students revealed a shortcoming in my graphic. While the information I had been sharing is correct, I needed to add another layer. Each of those four ways to trade has two possible outcomes! My next illustration would need eight more boxes.
I never want to leave my readers and online students with any unanswered questions - whether they whether they know they need to ask or not!
So, I got to work.
This post will take you through some of the basic information about option trading and contracts that you can find in my published content. The new, expanded, 8-row chart is at the end.
Let’s start with the most fundamental concept, the relationship between stock and options. They are related but they work differently.
Stocks are pretty simple. When you buy shares of stock, you own them. You can keep them or sell them or even pass them on to your heirs.
You can buy shares of stocks
You can sell shares of stocks.
A broker (or online brokerage service) matches sellers to buyers on a stock exchange, so you never really know who you are buying from or who you are selling to.
You aim to buy stock at a good price and sell for a higher price.
You can own stock for a short time or a long time.
Options, on the other hand, are much more complicated. They are contracts with an expiration date. Each contract creates a right or an obligation to buy or sell shares of stock. Each option contract has its own expiration date and an agreement about the price at which shares could potentially change hands. That agreed-upon price is called the strike price.
There are two types of options contracts and two ways to trade each of them.
The two types of options are puts and calls. The two ways to trade them are selling or buying. When you sell a contract, you are called the “writer” of the option. Many people use the terms “sell” and “write” interchangeably when they discuss options.
You can sell or buy an option contract that creates an obligation or a right to buy or sell stock.
Sellers get paid to take on obligations to buy or sell, and buyers pay for rights to buy or sell.
Since selling options is usually less risky than buying them, I advocate for beginners to start with selling, and I explain things mostly from the point of view of the option seller. But since you can’t sell anything without a willing buyer, I do talk about the option buyer a little bit as well.
A put contract- is an agreement for the seller (“writer”) of the contract to accept assignment to buy 100 shares of stock at a specific price (the strike price) any time up to a specific date (the expiration date).
A call contract- is an agreement for the seller (“writer”) of the contract to accept assignment to sell 100 shares of stock to the buyer at the strike price up to the expiration date.
The buyer of either type of contract has a right to demand the shares change hands at the agreed-upon strike price.
When you sell an option contract, make sure you know exactly what you are being paid for! What are you selling, and what obligation are you assuming?
As you saw in the chart above, since puts and calls can be both bought and sold, there are actually four types of option contracts. You can sell a put, buy a put, sell a call, or buy a call.
If you Sell a put- You get money up front. The buyer of the put has the right to require you to buy 100 shares of their stock at the strike price you agreed to when you wrote the contract, any time until the option expires.
If you Buy a put- You pay money up front. You can then force a seller of the put to buy 100 shares of your stock at the strike price, any time until the option expires.
If you Sell a call- You get money up front. Someone who bought the call can require you to sell 100 shares of your stock, at the strike price, any time until the option expires.
If you Buy a call- You pay money up front. You can then force a seller of the call to sell you 100 shares of the stock, at the strike price, any time up to expiration date.
You have a better chance of making consistent money as an option seller than as a buyer, but you need to be prepared for possible assignment. Depending on your investment goals, you may even hope to be assigned to buy or sell the underlying stock.
Be prepared for assignment, even though it might not happen.
If you write (sell) a put, you need to be prepared to buy 100 shares of stock at the strike price.
If you write (sell) a call, you need to be prepared to deliver 100 shares of stock at the strike price.
( See The Novice Investor's Guide to Stock, Funds, and Options, Chapter 3, Lesson 58 for a deeper explanation of safe trading and the collateral needed to secure your trades.)
But often the option contract expires without any stock changing hands. The contract is just an option to buy or sell at the discretion of the option buyer. So sometimes, the buyer of an option contract does not exercise their right to force a stock trade because there is no financial advantage for doing so at the agreed-upon strike price. If that happens, the option expires worthless. Either way, the seller of the option still keeps the premium they earned up front when they initially sold to open the option contract.
I strongly recommend you start your option trading journey as the seller, rather than the buyer, of any option contracts you trade. But let's take a look at both sides of the trade.
At expiration, every contract is either in the money or out of the money, so there are two possible outcomes for each of the four ways to trade. (If you are unclear about moneyness, you can check out Chapter 3, Section 5, Lesson 61 of The Novice Investor's Guide to Stocks, Funds, and Options.)
While you may take action to alter or end the contract, for right now, we are just looking at the substantive meaning of the option. This chart emphasizes the actual terms of the contract you are entering when you buy or sell to open an option trade.
Note: Trade management is the topic of a whole new course and book chapter I'm writing, so I'm not addressing it here. But I'd like you to know that as an option seller, you do have many available choices for managing a trade that does not go as you expect.
So here is that new chart with a column for moneyness and eight(!) possible outcomes of the four ways to trade the two types of option contracts.
Oh, and before any pedantic analysts (I'm looking at you, redditors) tell me I'm oversimplifying, please remember that I teach novice investors and option traders! I strongly believe my students will become better and more successful traders of options if they start with the basics, understand the contracts, and learn ways to use options to support their long-term investments. That's complicated enough to start with, and for most investors, it's as complicated as they ever need to make their options trades anyway.
So while I know that
options can be sold on things other than stocks,
there are even more complex combinations of trades with funny names that are based on their profit/loss graphs (condors and butterflies etc.), and
it is possible to trade options without understanding that the contracts are derivatives, or even what they really mean,
I don't start there with my students.
The value, risk and structure of option contracts are derived from agreements about the exchange of actual underlying assets. Trading without taking into account that part of the contract is just gambling.
So if you have made it this far, I hope you will trade safely, choose your underlying assets as carefully as you choose your strike prices and expiration dates, understand your risks, and guard your treasure. And if you need a hand getting started, reach out and ask me for help.