Understanding Options For Newbs Part I: What is an option?

This is the first post in a series where I’ll be explaining stock Options: what they are, how they work, and how to understand them well enough so you can try your hand at buying and selling them. And hopefully turning a profit. ;)

An option contract, better known colloquially as just “an option,” is technically just the right to purchase or sell shares of a stock at a given price – the option’s strike price, which I’ll elaborate on further down. But here’s an example: Let’s say you want to buy a call option for, say, Under Armour, Inc. (yeah, the sports clothing company, did you know they were publicly traded? Don’t lie!), which is priced at $21.39 per share as I write this (closing price on April 23, 2009). The call option gives you the owner the right to purchase shares at the option’s strike price. If you buy that call with a strike price of 20.00, which is valued at $2.00 right now, what you’ve effectively done is buy the rights to purchase 100 shares at $20.00 per share. So the strike price is the price that you can actually buy/sell shares at.

Here’s what an options chart looks like (I know, it can be damn intimidating at first, but take a breath and chill out for a second. I’m going to walk you through this over the course of this Options Series):

In this chart, the “Strike” column shows each option’s strike price. The actual value of the option is the “Last” column, which is the price that that stock option was last traded at. The “Chg” column is how much the value of the option has changed that day, by percentage. Don’t worry about the rest of the columns for now, we’ll get there in a future installment.

By now you might be asking yourself, “Where the hell did these 100 shares come from!? I just wanted to buy ONE option!” Here’s the deal: each option contract is actually a contract to purchase 100 options. In other words, you’re purchasing the ability to have 100 options of buying shares of a stock at that strike price, but you don’t have to buy those shares. It’s an option, not an obligation. If you do buy those shares, that’s called “exercising an option.”

This 100-shares-per-contract concept is the hardest thing to wrap your head around at first, in my experience. In the options chart you just see the regular strike price. Brokerages advertise their commission fees as $7-12 per single transaction PLUS $0.70-1.25 per one contract. They never talk about these things in plural, but that option that costs $2.00 (remember, this is not the strike price) is actually costing you $200! That’s $2×100 for you math whizzes out there. ;)

Oh by the way, options are always traded by the hundreds, so you can’t decide to buy one share and have 99 options left. It just doesn’t work that way.

On the other side of the ticker, a put option is one in which the strike price is the price at which you have the right to sell 100 shares. So if you buy the Under Armour put option with the strike price at 20.00, and then the actual stock price dips to $19.00/share, then that put is very valuable. The option owner can theoretically buy 100 shares at $19 each and then turn around and sell them at $20 each for a profit of 100 big smackers! Of course, there are quite a few details I’m leaving out here that make exercising your option potentially unprofitable (or less profitable than just selling the option).

In fact, only about 30% of options get exercised before their expiration dates. Oh right, those options you just sank $200 into will be rendered worthless in a few short weeks. This is reflected in the above options chart in the upper right hand corner where it says, “Expire at close.” This will also be covered in a future installment. Did I mention stock options are quite complex? I mean, you have to sign extra forms just to be able to trade them(!) because you can lose a lot of money very quickly if you don’t know understand what’s going on.

If the market were cut and dry then any time you could turn a profit by exercising your options you would invariably do just that, right? But the market is more like a crazy twelve-headed beast of Greek mythical proportions that you have to figure out, disfigured face by disfigured face, until you think you’re ready to tackle the she-witch.

So what have we learned today? Well, we learned that an option contract translates to the ability to purchase 100 shares of a stock at the option’s strike price. A call option gives you the ability to purchase 100 shares at the option’s strike price, and a put option lets you sell 100 shares at that option’s strike price. Dems da basics! Please make sure you understand this well because everything that comes after this is based on the fundamental understanding of what an options contract is. If you’ve got questions, I’ll see ya in the comments section.

*If you’re curious, Under Armour’s stock symbol is UA. Creative huh? Personally, I was surprised that that wasn’t already taken by a huge company like United Airlines or something.


2 Responses to Understanding Options For Newbs Part I: What is an option?

  1. […] Options For Newbs Part Ia: What is an option? In the last post I discussed what an option is most in terms of money. But you should also know where these options […]

  2. […] For Newbs: Expiration This is episode 3 of Understanding Options for Newbs, so by now we know what options are and what they mean. This is going to be a short, but important post. Plus, the next one’s […]

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