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doctorpot1
wrote a post10/27/2022 09:04
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Explained Simply: Options 101

In this Options 101 for layman, we will start with very simplified concept then slowly build up the concept, and then discuss some very basic option strategy you can apply immediately. This 101 only covers the very basics, so that you can get started with options. For more advance stuff, more Explained Simply posts will be coming Smile
Let's get started
In options trading, we first need to understand 2 fundamental concepts for options. Which is CALL option and PUT option.
CALL option
Super simplied concept of a CALL option
Super simplied concept of a CALL option
In the stock market context and to simplify it first, we can think of a CALL option as "a promise to sell shares". So, when you buy a CALL option, you bought someone's "promise to sell shares" to you. If you sell a CALL option, you sold "a promise to sell shares" to the buyer.

So if you buy a CALL option you could force someone to sell shares to you because they promised you. If you sold a CALL option, someone could force you to sell shares to them because you promised them.
PUT options
Super simplied concept of a PUT option
Super simplied concept of a PUT option
In the stock market context and to simplify it first, we can think of a PUT option as "a promise to buy shares". So, when you buy a PUT option, you bought someone's "promise to buy shares" from you. If you sell a PUT option, you sold a "promise to buy shares" from the buyer.

So if you buy a PUT option you could force someone to buy shares from you because they promised you. If you sold a PUT option, someone could force you to buy shares from them because you promised them.
Obligations vs choice to exercise
So, what you can see here is that the seller is the one that promised the buyer. The buyer bought a promise from the seller. The buyer did not give any promises, the buyer only paid money to buy the promise. So, the buyer of options doesn't have any obligation, but the seller has.
If you made a promise to someone, you must fulfil it.
So as a buyer of options, you can force the seller to fulfil the promise to you, or don't if you don't want to. If you want to force the seller to fulfil the promise, you can choose to exercise your rights. But the seller doesn't have a choice.
Options basic details
So now that we have understood the basic principle of options, let's go a little bit into the basic details on the options. There are 6 basic details that we need to focus on 1) the underlying asset, 2) the contract multiplier, 3) the contract type, 4) the premium, 5) the strike price and 6) the expiry date. All the details can be found in the highlighted boxes below.
Where to look for the details in Moo Moo's option page
Where to look for the details in Moo Moo's option page
Underlying asset: Since an option is a promise to buy or sell shares, it should say which company's share. Otherwise, it will be a blank cheque and the buyer can demand for $Berkshire Hathaway-A(BRK.A.US)$'s $436k a share shares. Thus, an option is tagged to an underlying asset which is a specific company's share. In this screenshot, the underlying shares is $Twitter (Delisted)(TWTR.US)$'s shares. The name of the option will also start with the share's ticker. Like in this example the option's name is TWTR230120P25000, which is Twitter's ticker symbol.
Contract multiplier: Each option is also for a certain number of shares. In US, it is generally 100 shares per option contract. In HK market some options might be 100 shares (like $HKEX(00388.HK)$), some might be for 1000 shares (like $Haidilao International Holding(06862.HK)$), some might be 2500 shares (like $SMIC(00981.HK)$), and so on. This can be found under the Multiplier section as seen in the picture above.
Contract Type: There are 2 types of option contract, American and European. For American type, the buyer can exercise the option any time prior to the expiration date. However, for European type, the buyer can only exercise the option on the expiration date. Most stock options are American type, but it is good to just check it. This can be found under the Type section as seen in the picture above.
Premium: No one in the stock market will do things for free. The seller took some risk by promising the buyer something, so the seller should be compensated for it. Premium is the money that is given to the seller to purchase his "promise". If you are the seller of the options, then this is money for you for taking on the risk. Once the money is paid, there is no taking it back. The seller will keep the money regardless if the buyer exercises the option or not.
This is basically the price you see in the picture above. This price is quoted as premium per share. If the contract multiplier is 100, the total premium to be paid needs to be multiplied by 100 as well. So, in the screenshot above, the price is $0.160 and since the multiplier is 100, the total premium for one option is $16.
Strike price: This is the price that is set to buy or sell the shares at. So, if the strike price is $25, regardless of how much the actual shares are worth, the shares will be bought or sold at $25 if the buyer choose to exercise the options.
This can be found under the Strike section as seen in the picture above. The name of the option will also end with the strike price. Like in this example the option's name is TWTR230120P25000, which mean $25.000 is the strike price.
Expiry date: It is hard for human to keep their promises forever. It is also hard on the seller if the seller's promise is forever. Thus, each option has an expiry date as well. After this expiry date the promise will be invalid. So, prior to this expiration date, this promise is worth something; But after the expiry date, it is worthless.
This can be found under the Days to Maturity section as seen in the picture above, as well as the actual date when you are choosing it in the options chain. The name of the option will also contain the expiry date in a YYMMDD format. Like in this example the option's name is TWTR230120P25000, which mean this option's expiry date is on the 20th of Jan 2023.
Bonus tip: You might be wondering since most of the options details are in the name of the option, then can we know if it is a PUT or a CALL option from the option's name? Yes, you can! in this example the option's name is TWTR230120P25000, P is for PUT option, and C is for CALL option.
Expanded Model on option
Now that we understand the basics, let's improve the concept of the super simplified model.
Simplified concept of a typical American type CALL option in the US market
Simplified concept of a typical American type CALL option in the US market
A simple way to look at CALL options contract now is that "Seller promise to sell 100 shares to buyer at the strike price, if the buyer wants, anytime on or before the expiry date, for a premium". Or in another words, "the buyer of a CALL options can choose to buy 100 shares at the strike price from the seller, anytime on or before the expiry date"
Simplified concept of a typical American type PUT option in the US market
Simplified concept of a typical American type PUT option in the US market
And a simple way to look at PUT options contract now is that "Seller promise to buy 100 shares from buyer at the strike price, if the buyer wants, anytime on or before the expiry date, for a premium". Or in another words, "the buyer of a PUT options can choose to sell 100 shares at the strike price to the seller, anytime on or before the expiry date"
Common misconception
One of the most common misconceptions that new options trader have is this.
The stock's price is now at $50. If I buy a CALL option with a strike of $10 and exercise it, I can force the option seller to sell me 100 shares for $10 each and I earn $40 per share immediately by selling the shares for $50. Infinite money glitch?
No, it is not. This is because the premium would be more than $40. The premium might be $41. So, by doing so you will lose $100 immediately. Why because you use $4,100 ($41x100) to buy the CALL option, then you exercise it immediately and paid $1,000 ($10x100) for the 100 shares, that is a total of $5,100. If you sold the 100 shares for $50 each that gives you $5,000. Paying $5,100 to earn $5,000.
Closing an option
So, what happens when you regret your decision, or accidentally traded the wrong option, or you want to take profit or loss? Do you have to wait till expiry date or exercise the option to close?
Nope you don't. You can think of it like buying and selling normal stocks. If you accidentally bought 10 shares, to close you just need to sell those 10 shares. Or if you had made a huge profit by buying 10 shares, you just sell the same 10 shares to clock the profit. So same thing in options, you can close the position by either selling or buying back the exact same option.
If you bought 5 $Disney(DIS.US)$ CALL options (with a strike of $100 expiring 20 Jan 2023), you just need to sell the exact same 5 $Disney(DIS.US)$ CALL options, to close the position. Make sure it is the exact same one.
If you sold 5 $Tesla(TSLA.US)$ CALL options (with a strike of $100 expiring 20 Jan 2023), you just need to buyback the exact same 5 $Tesla(TSLA.US)$ CALL options, to close the position. Make sure it is the exact same one.
Basic option usage
So now that we understand the very basic component of options, how might we be able to use it? There is only 4 ways you can trade options. 1) Buy a CALL option, 2) Buy a PUT option, 3) Sell a CALL option, and 4) Sell a PUT option. With just these 4 ways, you can mix and match them to create advance trading strategies especially when you include buying and shorting shares. For this options 101 post, I will only talk about the basic 4 individually on its own. On top of that, in the example the options are assumed to be sold or exercise on expiry for simplicity's sake.
disclaimer: The examples used are not recommendation or financial advice, but only used for educational purposes.
1) Buying CALL options
You generally buy CALL options if you believe the share price will go up higher in the short term before the expiry date. Price of CALL options generally goes up as the share price rises. But why don't we buy the shares instead? With CALL option you can 1) use leverage, or 2) use it for downside protection if you fear that you might be wrong. Let's use a well-known beaten down China stock for an example that is $Alibaba(BABA.US)$. At its peak, BABA hit an all-time high of $319.32; But now it is trading at $68.35 (78% crash).
1.1. Leverage play
If you are a super BABA bull and you are thinking this is the bottom (after calling the bottom a million times), and you want to go all in. If you want to use leverage, but you don't want to borrow money from the bank. Well, this is where CALL options can help.
Alibaba (BABA) $70 CALL option expiring 20 Jan 2023 when BABA is $68.35
Alibaba (BABA) $70 CALL option expiring 20 Jan 2023 when BABA is $68.35
If you look at the price of this BABA CALL option with a strike price of $70, the premium per CALL option is $740. For just $740 you can get exposure to 100 shares. If you want exposure to 100 BABA shares by buying the shares, that will cost $6,835. That is a 9x difference. With $6,835 you can buy 9x CALL options giving you exposure to 900 BABA shares, and still have $175 spare.
If BABA goes back to $200 a share before expiry. You get to force the seller of the option to sell you 900 shares of BABA at $70 each, and you could sell them at $200. Thus you just earnt yourself a whopping $110,340 ((($200-$70)*900)-(9*$740)). If you bought 100 BABA shares instead, you would have earnt yourself $13,165 ($200*100-$6,835). Now that is what we call leverage baby Keep FightingKeep Fighting.
But what is the risk with the options way? If BABA keeps crashing and is stays below $70 a share. Then you will lose everything! EVERYTHING! All $6,600 you paid for the 9 option! DizzyDizzy It is a huge gamble when you use leverage, you win big, you lose big. That's the case when we use leverage. Not recommended in a bear market, but in a bull market maybe a little won't hurt. Since even monkey picking stocks can outperformed S&P500 in a bull market ChuckleChuckle
1.2. downside protection play
For the BABA bull who aren't trying to YOLO, you might also be thinking this is the bottom. But compared to the ape above, your gut is saying "But what if you're wrong? what if it crashes to $50? but what if you are right and this is the bottom?" What a headache. Well, the same CALL option can help as well.
So instead of spending $6,835 to buy 100 shares and expose yourself to the risk. You could just buy 1 CALL option. You paid a premium to "chope" 100 shares. Yes overall, it is more expensive, but you are risking lesser capital. Only $740, and you could put the remaining $6,095 into $Fullerton SGD Cash Fund(SG9999005961.FD)$ to earn you some extra 3%, or some other places.
If BABA really goes back to $200 a share before expiry, now you can pay $7,000 to get 100 shares worth $20,000. Then just HODL and wait for it to reach the moon, or just sell the option and collect your profit of $12,260 ($20,000 - $7,000 - $740). However, if you are wrong, and BABA did not cross $70, then all you can lose is the $740 max.
brain teaser: This method is technically the same as buying 100 shares and buying a PUT option, but let's talk about it in future episodes.
2) Buying PUT options
You generally buy PUT options if you believe the share price will drop lower in the short term before the expiry date. Price of PUT options generally goes up as the share price drops. But why don't we just sell the shares or better yet short it? Well, what if the share price doesn't drop and keep climbing higher and higher? Furthermore, shorting is risky, you can lose an infinite amount of money, but your profit potential is limited.
With PUT option you can use it as a 1) safer way to short the stock, or 2) use it to protect your existing shares. Let's use a stock that many people are saying "they are going to be the next Lehman Brother" for example and that is $Credit Suisse(CS.US)$. At its peak, CS's shares were at an all-time high of $52.682; But now it is trading at $4.825 (90% crash). They are going to announce something big on 27 October 2022.
2.1. a safer way to short
Maybe you are one of the bears thinking that CS is going to be bankrupt, and you want to short the stock. Let's say you short 100 shares at the current price and you collected $482.50. You are hoping the share price will fall so that you can buy back the 100 shares you shorted and profit the difference. However, trading of CS shares is suspended suddenly as there is an announcement to be made. To your horror, $UBS Group(UBS.US)$ offered to buy CS out at $30 a share. The moment everyone can start trading again, the price of the shares gap up to $29. Because who is going to sell you the shares at $10 or $20 when they can sell it to UBS at $30 right? Well now you can only stop loss by buying back 100 shares at $29 each, so you lost $2,417.50 ($482.50-$2,900).
Credit Suisse (CS) $4.50 PUT option expiring 18 Nov 2022 when CS is $4.825
Credit Suisse (CS) $4.50 PUT option expiring 18 Nov 2022 when CS is $4.825
An alternative is to buy a PUT option. This PUT option with a strike price of $4.50 is only going for $30 each. The max you can lose is $30 as compared to infinity when you short the stock. Let's say CS crashed to $2.50. Well congratulation, you can buy 100 shares of CS at $2.50 from the market and force the seller of the PUT option to buy them for $4.50 each. Raking in $170 in profit ($450 - $250 - $30) while risking only $30. If you were to short the stock directly at the market price of $4.825 each, you could have earnt $232.50 ($482.50 - $250) instead. But PUT options helps to limit your risk, and you'll probably sleep better at nightLaughLaugh
brain teaser: This method is technically the same as shorting 100 shares and buying a CALL option, but let's talk about it in future episodes.
2.2. a protection for your existing shares
Another way to use PUT options is to use it as a protection for your existing shares. This is probably great for a bear market, since most stock price will crash in this market. For this example, if you already own shares of CS and you are worried that the price of the stock may crash even further but you are unsure. You can buy an "insurance" by buying a PUT option.
By buying this specific $4.50 PUT option for $30, it gives you an option to sell away your shares at $4.50 each even if the share price crashed to $2.50. In case you don't want to sell your share away and still want to keep your share, you could just close the protective PUT option by selling it for a profit of $170 and keep the stock.
But if the share price goes to the moon, you just lose the premium you paid, that's all. Just like how real-life insurance works, you keep paying the premium, but you get nothing back unless shit hits the fan. Buying insurance for yourself is kind of like buying a PUT option on your own life ChuckleChuckle you are going short on your life LaughLaugh
3) Selling CALL options
Selling options is a lot riskier than buying options, because you as a seller is obligated to fulfil your promise. So, in this Options 101 post, I will only talk about safer strategies. For selling of CALL options, I would only talk about covered CALL option strategy. In this example I will use $NIO Inc(NIO.US)$ as an example. Nio is supposed to be the $Tesla(TSLA.US)$ of China, but its share price isn't going up and up like Tesla PanicPanic At its peak, NIO's shares were at an all-time high of $66.99; But now it is trading at $10.755 (84% crash).
If you recall, a seller of a CALL option might be forced to sell 100 shares at the strike price. So, if you sold a CALL option with at strike price of $25, you might be forced to sell 100 shares of NIO for $25 each even if NIO goes back up to $50. So, if you don't have the shares on hand, you would have to buy them at $50 just to sell them for $25. Not having shares on hand when you sell a CALL option, is known as a naked CALL. It's just as bad shorting the stock outright, you face unlimited loss potential, but a limit profit potential.
A covered CALL just means that you have the 100 shares in your possession for every CALL option sold. So that if you need to sell your shares, you are covered and safe. As the bear market is slowly destroying our portfolio, many of us are still diamond handing, determined to not sell our shares, while waiting for the bull market to come around. If you are sure that you have that diamond hands, then why not earn some extra income while diamond handing? You can sell covered CALL options at a price you are willing to let your shares go, or set at the target exit price for the fundamental analysis folk, and for the technical analysis folk at key resistance level.
NIO $25 CALL option expiring 19 Jan 2024 when NIO is $10.755
NIO $25 CALL option expiring 19 Jan 2024 when NIO is $10.755
If you would sell your shares when NIO is at $25, then you could sell this $25 PUT option expiring a year and a half from now. You would collect $106 immediately, for you to use it anyway you like. You can withdraw it to buy some fancy clothes, use it to buy more shares, or even use it to buy PUT options. Your money, your call. It's in your account after you sell the option, and the buyer can't take it away from you. It's yours forever.
So now all you need to do is wait and see if the buyer will exercise the CALL option. If the price of NIO is below $25, say $10. Then the option would most likely expire worthless, because why would the buyer wants to buy NIO from you at $25 when they can buy it cheaper from the market right? You earned the $106 and still keep the shares SmileSmile
If the price of NIO is above $25, say $50. They would most likely exercise the option, as they would have made money. Buy from you at $25, then sell it $50, great deal. As for you, hey you sold NIO at $25, the price you would have sold anyway. You made money, they made money, win-win Yeah!Yeah!
Many people might say, but you could have sold at $50 if you had not sold the CALL option. To them we say, "wa you so smart ah, you know that NIO will be $50 in a year's time. Didn't know you came from the future, so tomorrow lottery, what number ah?" TrickTrick No one can predict the price in the future, so if you would 100% sell NIO at $25, then when it hits $25, you would have sold it anyway. But in case, you have regrets and don't want to sell NIO at $25 anymore, no problem just closes the position.
4) Selling PUT options
For safer strategies that involves selling PUT options, I would only talk about cash secured PUT option strategy to buy shares. This is a strategy that Warren Buffett, the king of investing, used himself. In this example I will use $Palantir(PLTR.US)$ as an example. PLTR is supposed to be the $Amazon(AMZN.US)$ of AI, with 7 years headstart in AI technology against their competitors but its share price isn't going up and up like Amazon PanicPanic At its peak, PLTR's shares were at an all-time high of $45; But now it is trading at $8.575 (81% crash).
If you recall, a seller of a PUT option might be forced to buy 100 shares at the strike price. So, if you sold a PUT option with at strike price of $8, you might be force to buy 100 shares of PLTR for $800, $8 per shares. Even if PLTR crash to $5, you are buying them. So, you better have that cash on hand if you don't want to get margin called.
A cash secured PUT just means that you have the cash in hand to fulfil your obligations. So, if you need to buy those shares, you are covered and safe. Since the cash is idling you could put it in $CSOP USD Money Market Fund(SGXZ96797238.FD)$ to earn an extra 3% too. Using cash secure PUT strategy you can sell them at a strike price you are willing to buy shares at, or set at the target entry price for the fundamental analysis folk, and for the technical analysis folk at key support level.
Palatir (PLTR) $8 PUT option expiring 18 Nov 2022 when PLTR is $8.575
Palatir (PLTR) $8 PUT option expiring 18 Nov 2022 when PLTR is $8.575
For this example, if you are willing to buy shares of PLTR at $8, then you could sell a PUT option with a strike price of $8 and collect a premium of $42, it's yours forever. Did you just hear that you can get money just by trying to buy shares? Yes, you did.
So, if PLTR remains above $8, say $10, then the buyer of the options would most likely not exercise it. Because why would they sell PLTR to you at $8 when they can sell it for $10 in the market right? You earned the $42 and nothing happened SmileSmile
If PLTR's price falls to say $5, then the buyer would most likely exercise the option and force you to buy 100 shares at $8. They can buy shares from the market at $5 and sell them to you at $8, another great deal. As for you, yayyyyy CheerleadCheerlead You get your shares at the price you wanted, the buyer of the option earned money from the options. Win-win again.
But since the price of PLTR is $5 and you bought it at $8, you will have a paper loss of $3 a share. But hey, this PUT option kind of forces you to act. How many times have we said, "I will buy if the price fall to $X", but chicken out when it really crashes to $X? If we sold a PUT option, then we are forced to do what we said.
brain teaser: By rotating cash secure PUT and covered CALL on a stock, you created what is known as a triple income strategy known as the WHEEL strategy, but let's talk about it in future episodes or you can just Google it. Tons of Youtubers are talking about it.
Conclusion
Options gives you options.
It allows you to create pay out that is not attainable by simply buying and selling shares. And by combining multiple options and even shares, we can create many trades possibility. Even 100% guaranteed profit by arbitrage or by using the holy grail of options strategy, the box spread. It exists, but it is out of reach to us retail investors. That is because high-frequency traders build bots to scan for such opportunities and they will snap it up within microseconds. Before we can even see the price, it is gone.
But there are still many options strategies that we retail investors can use to improve our investment. I left a lot of brain teasers along the post to intrigue you to explore them on your own further. So, you could either wait for the next instalment of Explained Simply: Options or go Google it Joyful Feel free to ask any questions in the comment section, and until next time, invest safe!!
Additional Notes
Options underlying need not be just shares of companies, it can also be houses, commodities, currencies, and so on.
The underlying and multiplier of an options contract may change too if there are corporate action like stock split, spin off, etc. For 101 we won't cover these adjustments as this aren't majority of the options contract.
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