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Breaking down options

Lesson in Course: Derivatives and options (beginner, 4min)

I can see that options are very different than stocks. What is in an option that makes them so different?

Eureka!

What it's about: Every options contract is made up of the same 5 components.

Why it's important: These components drive the value behind our options.

Key takeaway: The maturity, underlying, and strike price of an option helps determine an option's price.

Options can seem more intimidating than stocks as we start out. There is a bit more complexity involved in the different parts of options when misunderstanding something can have negative consequences. We're going to simplify things first by imagining that one of our friends has just asked us if we'd like to go to a concert with them. 

"What concert costs only 45 cents?...
50 Cent ft. Nickleback"

Some immediate questions that come to mind before we say yes are, "What band? When is it? and How much does it cost?" These are questions we should be asking about options as well.

What is it?

An options contract is often used interchangeably to describe a stock option.

What is Stock option?

A stock option is a contract between two investors that gives the holder the right, but no obligation, to buy or sell stock in the company at a predetermined price.

While a stock option is an option contract, not all option contacts are stock options.

Options contracts are recorded agreements to buy or sell any assets in the future

Some option contracts cover other types of underlying assets.

What is Underlying?

The underlying of an option is the asset promised to be purchased or sold between two investors within the options contract.

In most cases, the buyer and seller of an option contract make an agreement on the future sale or purchase of a stock of a public company. However, the investors aren't limited to only stocks and can make the underlying any other vehicle with a ticker. This can include ETFs, Mutual Funds, and REITs. The options contract between the investors represents an agreement to either buy or sell this underlying asset, and the value of the options contract depends on the price of the underlying. 

The 100 lot

Typically, a single option contract represents the right to purchase 100 shares of the underlying. A lot size of 100 shares is standard across all options contracts. The lot size brings a larger component of risk to stock options since one stock option exposes us to the price movement of 100 shares. Both gains and losses are magnified.

 

When is it?

Every options contract has a stated maturity date.

There is a time limit to the agreement
What is Maturity date?

The maturity of an option is the last trading date the contractual agreement is valid.

The option contract goes into effect the minute we purchase it through the end of the maturity date stated on the contract. After the maturity date, the option contract expires or becomes void. As a buyer, we can only pick from the available maturity dates presented by sellers. Once the maturity date is determined, it cannot be changed.

 

How much does it cost?

There are two different prices to consider for options. We learned above that an option contract is between two investors to buy or sell the underlying. The contract also needs to state the strike price the underlying can be bought or sold for.

What is Strike price?

The strike price is the price agreed upon between the buyer and seller of the option contract to buy or sell the underlying.

Specifically, the strike price for a call option is the price the holder can buy the underlying from the seller of the call option and the strike price for a put option is the price the option holder can sell the underlying to the seller of the put option. Since we can buy or sell an option agreement, there must also be an option price.

To become an option holder, we need to purchase the contract
What is Option price?

The option price is the current market price that an option contract can be purchased.

Not to be confused with the strike price, the option price represents the lowest cost a seller is charging for the options contract. The option price can also represent the current value for option holders. It's important to note that the option price is quoted on the price per share for the contract and we need to multiply by the share count covered by the contract(s) to arrive at the total cost.

Total cost example

For example, the option price for a $9 strike price call option on Ford stock($F) is $2 per share. The cost to buy one contract requires us to multiply the price by the lot size ($2.00 x 100) for a total cost of $200. Two contracts would cost us $400 ($2.00 x 100 x 2), and so on.

 

Here is an example of where to find most of these components within the user interface of a mobile trading platform like Robinhood.

Call option on Robinhood

Actionable ideas

No matter the type of options, every contract will have a unique combination of these five components. We should get familiar and comfortable with these components as they will build directly into basic and advanced strategies. Do we feel confident enough to explain these concepts to a friend? Invite them today to learn along aside you.

Glossary

What is Stock option?

A stock option is a contract between two investors that gives the holder the right, but no obligation, to buy or sell stock in the company at a predetermined price.

What is Maturity date ?

The maturity or expiration date of an option is the last date the contractual agreement is valid. After which, we can no longer exercise the option nor will there be any value left on the option agreement. 

What is Strike price ?

The strike price is the price at which the underlying will be delivered should the holder of an option choose to exercise their right to buy or sell.

What is Option price ?

The option price is the current market price that an option contract can be purchased.

What is Underlying?

The underlying of an option is the asset promised to be purchased or sold between two investors within the option contract.

Underlying assets are often stocks, mutual funds, ETFs or REITs.