【Options ABC】Options Concepts: A Beginner's Guide with ABC Story

Hello everyone and welcome back to moomoo. I'm Options Explorer and in today's episode of [Options ABC], we'll be covering the most basic concepts of options trading.
With the US earnings season underway, many investors are eager to start trading options but may feel unsure about where to begin.
If you want to make money from options trading, it's important to understand the fundamentals before diving in.
So, let's start with the basics and explore what options trading is all about. By building a foundation of knowledge, you'll be able to confidently navigate the market during earnings season and make informed investment decisions.

An option contract can be broken into two parts: "option" and "contract". "Option" refers to the right to buy or sell an underlying asset at a predetermined price before a specified expiration date, while "contract" refers to the agreement made between the buyer and seller.
Simply put, options are contracts that give the holder the right to buy or sell an underlying asset at a fixed price in the future, such as stocks and ETFs.
If this concept seems confusing at first, don't worry! Let me provide you with an example to help clarify things.

Let's say Alice wants to buy a house and enters into a contract with a property developer. The contract specifies that Alice will pay 5 million dollars for the house, which will be delivered in one month's time. To secure the purchase, Alice pays an upfront deposit of 200 thousand dollars.

In this situation, Alice can be viewed as the buyer of an option, while the property developer is like the seller of an option. Their agreement is similar to an options contract: Alice has the right to buy the house, while the property developer has the obligation to sell it.

If Alice decides not to proceed with the purchase, she will lose her deposit of 200 thousand dollars. However, if the value of the house increases and its price rises above 5.2 million dollars, Alice stands to profit. Conversely, if the value of the house decreases and its price falls below 5.2 million dollars, Alice will suffer a loss.

It's more likely the case that you expect the house to increase in value to over 5.2 million dollars. In other words, options trading is essentially based on your expectations of the future market.
Signing the property contract is like buying a call option. You expect the price of the house to rise above 5.2 million dollars, making the agreement a favorable deal for you.

You might expect the house to be below 5.2 million dollars by expiration.
Signing the contract is like selling a call option. You expect the price of the house would not rise above 5.2 million dollars by expiration, so it seems like a good deal for him.
This example sheds light on the dynamics between the buyer and seller of a call option. The key takeaway is to consider buying a call option if you anticipate the underlying asset to appreciate in value by a certain timeframe and to consider selling a call option if you do not expect the asset price to rise, though selling options do come with additional risks to keep in mind.

Suppose Alice owns a car and fears it might get scratched. She signs a contract with an insurance company and pays 5,000 dollars for one year of coverage.

If the car sustains any damage within that one-year period, the insurance company will provide compensation of 20,000 dollars. However, if the car remains undamaged at the end of the year, the insurance company will not refund the 5,000 dollars paid upfront.

In this example, Alice can be viewed as the buyer of an option, while the insurance company is like the seller of an option. Their agreement is comparable to an options contract: Alice has the right to receive compensation if her car gets damaged, while the insurance company is obligated to compensate her.

It's likely the case that you expect your car to get damaged in the future.
By signing the contract, you are effectively buying a put protective option as you expect your car might get damaged, thus paying 5,000 dollars to receive insurance worth 20,000 dollars.

It would be beneficial for you if the car remains undamaged throughout the contract period.
By signing the contract, you're effectively selling a put option and expecting the car not to sustain any damage. You promise to provide compensation of 20,000 dollars only if the car is damaged.

This example highlights the relationship between the buyer and seller of a put option. The takeaway is that investors might consider buying a put option if they expect the underlying asset to depreciate in value, while selling a put option would make sense if they do not anticipate any decline in the asset price.

Next, let's take a closer look at the six essential elements of an option contract.

Undelying Assets: It could be stocks, ETFs, futures, bonds and funds.
Direction: Call (bullish) and put (Bearish).

Strike Price: It is the price at which an options contract allows investors to buy (in the case of a call) or sell (in the case of a put) the underlying asset before the contract expires. In Alice's house purchasing example, 5 million dollars could be regarded as the strike price for her options contract.

Premium: It is the income received by an investor who sells an options contract, or the current price of an options contract that has yet to expire. The premium value is constantly fluctuating with the price movement of the underlying assets. In Alice's examples, both the deposit paid for purchasing the house and the money paid to purchase car insurance can be considered as premiums.

Options can be categorized into in-the-money option (ITM option), at-the-money option (ATM option), and out-of-the-money option (OTM option).

For Call options:
In-the-money option (ITM option): strike price < current price
At-the-money option (ATM option): strike price = current price
Out-of-the-money option (OTM option): strike price > current price

For Put options:
In-the-money option (ITM option): strike price > current price
At-the-money option (ATM option): strike price = current price
Out-of-the-money option (OTM option): strike price < current price

The deeper options are in-the-money, the higher the premium. You may open Options Chains on moomoo to better understand ITM, ATM and OTM.

Expiration Date: The day when the option expires.

Contract Size: For US stock options, a standard contract covers 100 shares. For example, if Alice buys a Call of Microsoft at a price of US$10 per share, the total premium she needs to pay for opening the position will be US$10 * 100 = US$1,000.

By now, you should have learned some basics about options. Congratulations on taking the first step into the world of options!
But you may be wondering about the potential benefits of trading options. Generally speaking, options can potentially help investors in two ways.

Although many people associate options with high risk and volatility, they were originally designed as a hedging tool.

For instance, let's say Alice owns 100 shares of Tesla stock but is worried that its price will drop after an earnings report. She could buy a put option on Tesla to limit her potential losses during the life of the option if the price drops. If the price does increase, she will only lose the premium paid for purchasing the put option, which can be considered insurance bought for her position in Tesla's stock.

The leverage effect of options can be thrilling, as it allows relatively small amounts to potentially move much larger amounts. As a derivative instrument, options have a high profit/loss ratio. It is not uncommon for the value of an option to increase several times over. However, it's important to remember that profits and risks go hand-in-hand, and risk management must be carefully considered to avoid taking unnecessary risks.

However, all investment involves risks, and options trading can be risky. For one thing, options value can decline over time or become worthless if they expire out of the money. For another, options trading involves leverage, resulting in higher potential returns and losses. Hence, it is crucial for traders to have a solid understanding of options before taking any actions.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts.

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