As an introduction to options I would like to explain the terms or vocabulary used in option trading in an example first and then list the definitions. Let’s start with an example of one way to use a Put Option to buy a stock at a cheaper price.
Example one:
Andy wants to own Amazon stock, but it’s current price is $100.00 per share and he feels it’s over priced. He notices that while the general direction of the price has been upward, the price chart shows constant upward and downward movement. He is thinking of placing an order to buy the stock if it’s price falls to 95$. He is counting on someone who just bought the stock at 100$ wanting to sell it, if the price falls to 95$ to limit their losses on the expensive stock. Andy calls Bob the Broker (stock broker) and tells him he wants to place a limit order to buy the stock at 95$. Bob tells Andy that instead of placing a limit order, waiting to buy and not earning any money, he should sell a “Put Option”. He explains that a Put Option is like a contract, and if he sells one “contract” of a Put Option, he now has an obligation to buy “100 shares”, of the stock at the agreed upon sales price of 95$ per share, which is also called the “strike price”, until his Option expires on a date about 30 days in the future, a date called “the expiration date”. He explains to Andy that right now the Put Option on this stock sells for a payment, called a “premium” of 2$ per share or 200$ per contract. He tells Andy that if the market price of the stock is higher then the the agreed upon strike price on the expiration date, the buyer of the “Put Option” will not sell to him at 95$. But that Andy gets to keep the premium anyway. If the stock price falls below 95$ the Put Option buyer will sell him the stock for 95$, and Andy will have bought the stock at his desired price and earned 200$ extra in the process. The best part about this, is that because Andy was paid a 2$ per share premium for the Put Option contract, he can deduct 2$ per share from his stock price, so in reality the stock cost him only 93$ per share.
Let’s look at the numbers.
Amazon stock’s current market price is 100$.
Andy wants to buy 100 shares of Amazon, but only for 95$ per share.
Andy sells a Put Option contract,
-> for a “premium” of 2$ per share,
-> one contract controls 100 shares of stock,
-> the agreement lasts until the “expiration date”
-> Andy collects 200$, which he never has to give back.
There are two possible outcomes:
Outcome A:
The stock price remains above 95$, Andy’s Put Option expires and Andy keeps 200$.
The Put Option buyer keeps his stock and the agreement with Andy ends.
If the stock continues higher to 105$ Andy lost the chance to buy it at 100$.
Outcome B:
The stock price falls below 95$.
Andy buys 100 shares of Amazon for 95$.
Andy keeps the 200$ “premium” the Put Option buyer paid him.
Andy has actually bought the 100 shares for 93$.
Current price 100$ per share
“Premium” price 2$ per share
“Strike Price” price 95$ per share.
Andy’s actual price 95-2= 93$ per share, which is a big discount.
Discussion and Summary:
Andy wanted to buy a 100$ stock for 95$.
Andy sold a Put Option with a 95$ Strike Price.
Andy received a 2$ Premium per share or 200$ for his Option.
If the price went up instead of down Andy has lost the opportunity to own at 100$ this month and he might have to pay more next month. If the price goes down, Andy will be able to buy the stock at a big discount.
Some investors think Andy is wise to be patient and earn money while waiting to get the price he wants. Other investors think he is foolish because of the fear of missing out on a big increase in the market price. As an Options trader I think this is a win-win because I know that in general a stock can go up, down or sideways with each have the same or equal probability 33% each from day to day, but 2 of the possible outcomes or 66% probability the stock will go down or stay the same. So mathematically this is a safe bet on a stock I want to own, but if it doesn’t work out this week or this month there’s always next week or next month. I set up my trades to provide the best probability of a win on this trade. In this example, the premium is a win whether I get the stock or not.
✍🏼 by Shortsegments
Bonus Material
Option
An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.
Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium.
Premium
The amount of money per share you pay to purchase the option rights you seek, either to buy or sell stock share. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
Expiration Date
The Calender date that you rights to buy or sell end. An option is a temporary agreement with an end date agreed upon at the time of purchase.
Put Option
A Put option is an option contract in which the buyer has the right (but not the obligation) to sell a specified quantity of a stock or some other security, at a pre-determined price (strike price) until a pre-determined date (expiration).
For the seller of the Put option it represents an obligation to buy the underlying security at the strike price, if the option is exercised. The put option seller is paid money (premium) for taking on the risk associated with the obligation.
Contract multiplier is a Option term which refers to the number of shares or units of the underlying asset in one contract. So for stock options the multiplier is 100, which means each contract covers 100 shares.