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Buying an option

Lesson in Course: Derivatives and options (beginner, 6min)

I'm finding options less intimidating! What are the first steps I should take before buying options?

Eureka!

What it's about: Before we buy an option, we need to pick a direction and understand the available choices. 

Why it's important: The process of buying an option is much more complex than buying a stock.

Key takeaway: Option chains show us a menu of put and call options with different strike prices and maturity dates.

The simplest way to use options is to buy an option contract that covers a specific stock, ETF, or mutual fund. When buying an option contract, we are offered two choices, and depending on the choice we can expect very different results. 

Deciding on a direction

The first step is to come up with an informed opinion on the direction of a future stock price. 

Will the price of the underlying go up or down?

We purchase call options when we think the underlying stock will go up in value. We purchase put options when we think the underlying stock will go down in value

Let's dive into a short video by InTheMoney and learn more about the basics of call and put options.

InTheMoney
https://www.youtube.com/embed/SD7sw0bf1ms?start=87&end=560
 

Reading the menu

Next, we will need to take a look at the available options for purchase and decide if there's an appropriate one we'd like. The list of available options for purchase is presented differently than stocks in the form of an option chain

The option chain

Option chains are tables of put and call options for purchase organized by different strike prices and grouped by maturity date available.

Below is an example of an option chain for XYZ stock with a maturity date of January 15, 2021. 

Example of an option chain
Simple option chain

The Bid and Ask represent the prices buyers and sellers are quoting. For the time being, we can ignore these prices and just pay attention to the last price.

An option chain will always have the range of strike prices listed in the middle column with available calls and puts on either side. Each row contains the current market prices for the options contract for that strike price. Color shading is often applied to distinguish in-the-money options from out-of-the-money options—a topic we will cover in a later lesson. 

Can we spot the XYZ contracts for the option chain?

  1. $2.96 option price for January 15, 2021, $130 strike XYZ call options
  2. $9.15 option price for January 15, 2021, $130 strike XYZ put options

Option chains can look different depending on the platform.

Option chain on Robinhood

Below is a simplified user interface of an option chain on Robinhood. Outside of bids and asks, we should be able to locate the same information as above.

 

While options were originally created for individual stock, today we can actually buy call options on any underlying. This includes individual stocks, ETFs, REITs, and other levered products. The only securities we can't buy options on are other options (unless those other options are already bundled into an ETF).

Actionable ideas

We've just covered the first two steps every investor needs to take before buying an options contract. Being able to read an option chain allows us to understand the available options for purchase. As we continue to learn more about how the strike price, underlying stock price, and other factors impact the value of stock options, we'll be able to start picking specific options appropriate for us within the chain.