Stumped By Stock Options? Here’s The Intuitive, Chart-Free Explanation You Need
Options open up all sorts of great ways to very safely coax more returns out of your investments, or even just spare cash.
Ignore the course-slinging hucksters, ignore the occasionally lucky but degenerate speculators, and you’re left with an incredible tool in your financial toolbox.
Even as an avowed financial minimalist who loathes complexity, I think they’re swell.
The only problem is most folks don’t find options all that intuitive.
Everyone gets that we make money when stocks go up and lose money when they go down (short-sellers notwithstanding). That much is common knowledge. But options add about four different layers of complexity.
And when complexity reigns, some people fall prey to scoundrels who pretend to have some esoteric secret; others wind up taking a wild guess and losing big; still others, the luckiest of the bunch, simply do nothing. Now, doing nothing isn’t the end of the world, but I’d rather not leave money on the table!
You shouldn’t feel like you have to, either.
So if you’ve struggled to wrap your mind around what options really are, let alone how they work, then this just might be the totally painless intro that connects the dots.
There’s no avoiding some technical details down the road, even though I’ll gloss over them for our purposes here. You’ve simply got to get comfortable with charts and terminology before putting real money in play. But that’s all a thousand times easier once these general principles make sense.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
An example we can all relate to
You may not realize it, but you’ve already have everyday experiences where something just like options would have come in handy. Indulge me in reimagining a couple common situations, and you’ll see what I mean.
Think back to when you were a broke youngster, not the big baller flush with cash that you are today. Back when you had to plan to buy even small necessities.
With me?
There is a vacuum cleaner you’re undoubtedly going to need. But it’s $100, and you’re tight on cash, so you’ve been putting off the purchase. But one day you’re out window-shopping and notice that it’s marked down to $65. “Pretty good!” you thought. “I still need to wait until I get paid this Friday, but at that price I’ll definitely pick it up next weekend.”
Unfortunately, the weekend rolls around and the sale is over. It’s back to $100, but you still need it.
What if you’d had the chance to make the store’s manager an offer: “I’m not ready to pay $65 right now, but I know the sale won’t last forever. Can I pay you $5 right now and you’ll promise to let me have it for $65 this weekend no matter what?” By simply writing you a little note with that promise, the store would have made a few extra bucks right then, and you would have guaranteed at least some savings.
That promise was a call option.
Pretty reasonable, right?
You paid a few bucks for the privilege— not the obligation, just the privilege— to buy something later at a price determined now.
It also works the other way. Let’s say you’re trying to experience the life-changing magic of tidying up, and it’s finally time to get rid of that quirky chair that seemed charming in the faux-Indian decor section at World Market but nobody actually liked to sit in.
It’s worth an easy $50, without a doubt. But the same day you list it on Craigslist, you get one offer, and it’s for just $35. That’s not ideal; you’re still a broke youngster, after all, and that $50 would have more than made up for the vacuum sale you just missed.
You decline it, but the only ensuing Craigslist messages are…shall we say…less relevant. Then, finally, you get another offer. The only problem is it’s a $10 low-ball and they want you to deliver it to the next county. That’s a hard pass.
Just when you thought that was rock-bottom, it gets worse: pure silence thenceforth. It’s not like you’re going to drop the whole chair in the dumpster, so it seems you’re stuck with it for good. And so you pull up the email with that repugnant $10 offer to ask for their delivery address…
But let’s back up to that $35 offer. Understandably, you weren’t excited about it, but it wasn’t insulting, either. Given the chance, you might have emailed that person to say, “Well, I’m absolutely sure it’s worth more than that, but I guess I could be wrong. Why don’t I pay you $5 right now — yours to keep — and if it’s still for sale next Monday, then it’s all yours for $35 just like you planned.”
Sure, you’re out $5 more, but you avoid the non-trivial chance of having to drive 30 miles for peanuts.
That promise was a put option.
And that, too, seems pretty reasonable.
You paid a few bucks for the privilege — not the obligation, just the privilege — to sell something later at a price determined now.
To recap:
- You think something you want to buy will cost more in the future than it does now, so you pay some amount (a premium) to lock in a strike price to buy it at. That’s a call option.
- You think something you want to sell will be worth less in the future than it is now, so you pay some amount (again, a premium) to lock in a strike price to sell it at. That’s a put option.
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Now, let’s take it a step further. If you were actually talking to the vacuum cleaner store’s manager or to the chair buyer, how would you figure out how much that privilege should cost?
For starters, you’d want to know how much vacuum and chair prices actually fluctuate. Of course, our hypothetical deals are basically random events, so we can’t really know. But let’s pretend there are actually thousands of people buying that exact vacuum and selling that exact chair all the time. Suddenly you’d have a very good idea of how wild their prices really are.
If that vacuum has never once sold for more than $100, then it probably wouldn’t break $100 for the first time this weekend. Never say “never,” of course, but it’s not likely. In that case, locking in the $65 sale price is worth no more than the current $35 discount. You might pay $10 or $20 to secure it, since you still come out ahead. But if it costs you $35+ just to secure the $35 discount, you’d break even or lose money on the whole.
Now, say you’d seen that vacuum selling on eBay for upwards of $200 a couple times just last week, and other stores were sold out of it, and its manufacturer was about to become the Official Housekeeping Sponsor of the NBA. There’s a big chance of it costing more than $100 by the time you get paid on Friday. In fact, you have good reason to think it would reach $150 or more before the weekend, and could stay there for months.
But you need it this weekend. That means today’s $65 sale price represents not just a $35 discount from the usual $100, but effectively an $85 discount from the $150 you’d expect to pay later. Surely you’d be willing to spend $50, $60, or even $70 to lock in today’s price as a sort of insurance against the full $150. That’s not a great deal, but since you can’t buy right now, you’re better off paying $70 + $65 = $135 than paying the full $150 on Saturday!
And it’s the same but opposite deal with the chair. Say you knew similar chairs had never sold for less than $35, so no matter how long you hold out, you won’t have to settle for less than $50 - $35 = $15 off your asking price. In that case, you’d be out of your mind to pay more than $15 to lock in $35.
But what if the market was about to be flooded with cheap knock-offs, and the Consumer Product Safety Commission was about to recall this model anyhow? You’d count yourself lucky to find a future buyer for $10, a whopping $40 less than you’d like.
In that case, locking in that $35 is worth more than the $15 difference, since you’d otherwise have to settle for a dirt-cheap price. The mere right to a $35 sale might be $20 or even $25, depending on just how far you think the next-best price will plummet.
This, in brief, is volatility. It’s the magnitude and suddenness of price swings. And as the expected swings get bigger and swifter, the options become more valuable. Whenever you buy an option, the assumed volatility is already baked into the price you pay. Volatility assumptions change all the time, and therefore option prices do, too. That creates opportunities to speculate, which we’ll come back to near the end.
Time is money
Closely related to that is just how long you’re locking in the price for. More things could happen to the vacuum and chair markets in the entire next year than in the next few days.
Naturally, the vacuum store manager would charge you quite a bit more to lock in $65 for the next year than just until the weekend. Likewise with the chair: the privilege of selling it for $35 a year from now is worth a lot more than the privilege of selling it for $35 just until your Craigslist ad expires.
By the way, remember that if you did pay handsomely for the one-year agreement in either case, that agreement is worth a little bit less as each day passes without a dramatic price change.
This is an example of time value. Less could happen in 364 days than in 365, and still less in 363 than in 364, so it dwindles (or “decays”) every day, all else being equal.
What’s more, it decays more quickly with each passing day. After all, one passing day just 1% of the remaining time from 100 days out, but a whopping 50% when you’re only two days out.
It’s what’s inside that counts
Now that you’ve got a sense of volatility and time value in real life, here’s a question: on the day your agreements come to an end, what are they worth?
Remember, you paid a fee for the right to a price up through some date. There’s no calling up the other party in 2050 to say, “Hey, you might not remember me, but…”
Now we’ve finally hit that expiration date, so there’s no time left to pass. Only current prices are relevant, so current prices will tell us exactly what it’s worth at expiration.
For instance, perhaps the vacuum fell to just $64 and the chair actually has a buyer for $36. In that case your agreements aren’t worth the paper they’re printed on. Sure, those agreements gave you flexibility and peace of mind all along, but today, it would be silly to pay $65 or accept $35 (per the agreements) when you could pay $64 or accept $36 on the spot. You’re out the contract price either way, so you might as well be $1 better off now!
The market price is more favorable than the contract price, so these contracts are out of the money.
Conversely, if vacuums rocketed up to $250 and chairs fell $5, then your agreements would probably be worth quite a bit. In fact, they’d be worth exactly the difference between the agreement price and the market price. (Remember, no time is left for price swings now, so there’s zero time value to factor in.)
The market price is less favorable than the contract price, so these contracts are in the money.
This is another key concept, or rather a pair of them:
- Intrinsic value, or the simple difference in prices right at the moment. An out-of-the-money contract has none, whereas an in-the-money contract has potentially quite a lot. This is all that remains when you reach the end of the contract period. But it’s no good past the expiration date, just like a bet on the 2021 World Series wouldn’t apply in 2022.
- Extrinsic value is the “padding” for wild, unpredictable, volatile price swings in whatever time remains (if any). By its very definition, extrinsic value is gone when the expiration day winds to a close.
“What do you mean you’re out of stock?!”
Now, think about what would happen if you (the call buyer) went to take the vacuum store (the call seller ) up on the contract…and they had no more vacuums.
Bad news, right?
Likewise, what if you (the put buyer) went to take the person from Craigslist (the put seller) up on the contract…and they had no cash to make good on the deal?
Again, bad news!
They each accepted your money and wrote a legally binding contract to do business with you. Not only is it immoral and illegal to renege on these deals, but it would besmirch the good name of vacuum stores and the (perhaps slightly less) good name of Craigslist buyers forever.
If this whole arrangement is going to work, then you want to be able to take for granted that the vacuum store still has inventory and the chair buyer still has cash. Otherwise, chaos ensues.
This highlights the importance of collateral. Ideally, whoever’s writing (that’s options jargon for selling) a contract has the actual item to sell you or the cold, harsh cash to buy your item with (whichever applies). At the very least, the writer can draw on credit or to liquidate other possessions to make good at the last minute.
After all, the assumption that the writer has collateral or credit (known as “margin”) is the only reason you’d be comfortable entering this contract with them in the first place!
Now, put yourself in the contract writer’s shoes, and think of the risk of writing (selling) contracts against things you don’t even have.
Sometimes the contract buyer never wants to do the transaction.
That’s because the contract price is out of the money, meaning they’d get a better deal on the open market than by actually taking you up on the contract. In that case, the buyer lets it expire, you just keep the fee, and all’s well that ends well. You aren’t called upon (assigned) to follow through, so not having the item or the cash didn’t matter in the end.
But sometimes they do want to do the transaction.
That’s because contract is in the money, meaning they’d get a better deal at the agreed-upon price than on the open market. You are called upon, so now you’ve got to procure a vacuum at today’s higher market price to sell to them at a massive loss; or you’ve got to borrow money to buy a chair you don’t want and could’ve bought on the market for much less if you did.
It’s easy to see how writing options against assets you don’t own or cash you don’t have is a recipe for disaster. These so-called “naked options” have broken more than a few traders.
Just checking in…
Congrats on getting this far! Believe it or not, we’ve actually covered the fundamentals of options.
- Each contract involves two people, one of whom issues (or “writes”) the contract and one of whom buys and may exercise the contract.
- A call option is the right to buy an underlying item and a put option is the right to sell it.
- Options have intrinsic value, which is based on how far in or out of the money they are (i.e., whether the contract prices are appealing or unappealing compared to market prices).
- Options have extrinsic value, which is based on how volatile the underlying items are and how much time remains.
- Whoever writes the option is on the hook to follow through no matter what, so they need collateral and/or credit. That’s what gives you confidence to buy the option. Likewise, you yourself would need collateral or credit to write your own contracts.
Of course options pricing is a lot more complicated in reality. Researchers even won the Nobel Prize for some terrifying equations that model it. Fortunately, daily life (of sorts) affords plenty of opportunities to see the main concepts in action.
A note on speculation
We’re just about through with what I hope wasn’t the most boring thing you’ve read today.
You’ve probably noticed that this system creates all sorts of interesting incentives. As a parting exercise, let’s think through a couple major ones that will shed light on why the options market is such a popular venue for trading.
Assumption: the vacuum and chair markets (I hope you’re not as sick of these as I am!) are absolutely enormous. In fact, they’re so enormous that people follow general item prices, and speculate on them, and even buy and sell the options themselves without ever planning to touch an actual vacuum or chair.
In real life, an option isn’t the right to buy or sell a single share of the underlying thing. It’s actually the right to buy or sell 100 shares of the underlying thing. That means slight changes in the going rates of vacuums and chairs will cause enormous changes in the prices of vacuum and chair options.
That disproportionate (“leveraged”) relationship is why it’s so important to think about volatility.
If the market thinks vacuum prices are extremely stable at $100 give or take a buck, then a $105 call (buy) option good for three months will only be worth a little bit. The market assumes very little volatility, which plays out as very low contract prices.
But what if you have reason to think vacuum prices are actually quite volatile but the market just hasn’t realized it yet? In fact, you believe they’re on the verge of spiking to $150 and staying there for ages, but the market hasn’t caught on to that and therefore hasn’t priced it into the options yet.
If you’re right, then that same three-month $105 call is about to become extremely valuable, since $105 is a massive discount from that likely future price! Depending on your confidence (and appetite for risk), you could load up on several contracts in hopes of selling them later on for a profit.
You could even buy a call for a strike price that’s already less than the market price — let’s say for $95 — in hopes that it will get even more valuable. The fact that it’s in the money today means it’s less risky, since it has intrinsic value even if vacuum prices never rise after all. As long as it vacuum prices don’t fall below $95, it’s still worth at least a little bit (minus whatever time value has passed). But that contract’s lower risk also means it’s more expensive.
The key dilemma as a trader is that if the spike never happens — perhaps vacuum prices push up against $105 but never cross that point — then you lose money on that $105 option. You can sell it at a loss while it still has extrinsic (time) value left. You can also hold it right up until expiration, in hopes of a last-minute price spike, but it’ll more than likely expire worthless. You’re out the money you paid upfront, but no more than that.
It’s an equal but opposite situation with put (sell) options.
Say your fellow chair enthusiasts think government regulations will keep chairs selling for around $50. You, on the other hand, prognosticate a flooded marketing that drives them down to $10 at best. You might load up on put options (the right to sell) for $50 or a little less. If prices drop below whatever price you chose, then you’re in the money and walk away with a handsome profit. If not, then you’re out most or all of the amount you spent on the contract.
A quick note on risk
Of course, nobody wants to lose everything if they’re wrong. We may have strong and reasonable theories about the future, and we may even be right most of the time, but we don’t know the future. After all, that’s why there’s an options market in the first place.
That also means we have to be careful about risk. Risk gets very technical, very quickly, so we won’t even go there for now. Suffice to say that some options gain value when others lose value, so you can combine the two to balance each other out. You stand to earn less but also to lose less. Most importantly, you reduce or eliminate the chance of losing all you have and then some.
But that’s a topic for another day.
The view from the other side of the table
We’ve talked a lot about the option buyer’s perspective, but not so much about the option seller’s. Let’s briefly detour into the latter, since it brings up one last, critical point about the options market.
The vacuum itself will have value after next Saturday. Odds are good it’ll have value a year or even a decade after next Saturday, for that matter.
That’s in stark contrast to your vacuum-buying contract, which is worth something up through expiration, but not a penny after expiration.
What’s more, remember that the contract lost a little value each day up until expiration (assuming the price swing you expected didn’t happen). It also lost that value at an increasing rate as time went by.
If I wrote you a contract one month ago, but prices barely budged, then I could buy the contract back from you at a lower price today. If it expires tomorrow, the price will be dramatically lower than if it’s still good for another month. Less time means less potential for crazy things to happen, which means less value in the contract. This is the phenomenon of time decay in a nutshell.
That’s my profit and your loss, but we both benefit in other ways. You recoup at least some of your premium. I no longer have to bear the risk of fulfilling the contract at a huge loss if prices do swing at the last minute after all.
If the expected price swings don’t happen, then the option buyer loses money due to time decay while the option seller gains money due to time decay. It’s not strictly a zero-sum game, but it often looks that way on paper.
That raises an interesting question: is there a way to systematically make money from this phenomenon?
Why, yes. I’m glad you asked.
To learn how, check out my Foolproof Market Mastery Trading System, a $4,997 value for only $397. I’ve got just 43 copies of the PDF left, and this sale will never happen again since Wall Street hates me!!!
Just kidding. Punch me if I ever write that unironically.
In all seriousness, I use a couple of incredibly simple strategies to great effect. They’re too much to cover in this already verbose article, but I’ve briefly described them here for your perusal. And I promise there are no vacuums or chairs.
Parting thoughts
You’re still here and still awake. Congrats! And if even half of this made sense, then I’m flattered, and you’re in a good spot to dive into some more technical, realistic resources.
That leads me to two parting thoughts.
Firstly, don’t pay a penny for that information. Free guides abound, so peruse a few until you find something that clicks with how you like to learn. Investopedia has good, concise articles (like this) and the projectoption YouTube channel (start here) is an awesome video resource. There are countless other good sources, none of which charge for access, let alone up-sell you on “secret strategies” or “high-win-rate trading signals.”
Secondly, the only way to meaningfully learn is to start applying your knowledge. Start simple, using only strategies you understand with money you can afford to lose. But start. You’ll always have doubts and knowledge gaps, but experience will show you when and how to address them.
When it comes time to start, you’ll need a brokerage.
Robinhood is a household name these days, since they don’t charge any commissions or fees whatsoever. (Unless you dip into margin loans, which no beginner should even contemplate.) The desktop and mobile versions are remarkably intuitive, so your only learning curve is what you’re trading, not the platform you’re trading on.
Robinhood runs a little slow both in the UI and in order execution, which is a huge problem for day trading or other situations that require down-to-the-second timing. They’ve also had multi-hour outages in recent months, which is obviously worrisome, although I haven’t personally lost any money as a result.
You may eventually move to something more sophisticated, like TD Ameritrade’s excellent thinkorswim platform.
And while I haven’t tried Webull yet, I get the impression that it’s a great middle ground between the overly streamlined Robinhood and the more overwhelming professional tools.
With all that said, I still do nearly all my trading in Robinhood and just refer occasionally to other tools for chart analysis and profit/loss graphs.
The drawbacks I mentioned are nothing to sneeze at, but its ease of use keeps me there for the time being.
This, at long last, is the end.
You’re significantly closer to a profitable options trading side hustle, should you so choose. And should you pursue, remember three things.
Stay calm.
Stay curious.
Stay humble.
More than any tip or trick, those are what tilt the odds in your favor.
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