This is the bare bones basics of how option contracts work. There are two types of option contracts, a call and a put. A call is a contract that allows the buyer the right to buy an asset at a given price – called a strike price – at or before a certain date with no obligation to do so. On the flipside a put is a contract that allows the buyer the right to sell an asset at a given price. A typical contract allows you to buy or sell 100 stocks of a company at a given strike price. The amount of the asset the contract gives you the right to buy or sell is called the multiplier and the act of using this contract to buy or sell shares at a given price is called exercising the contract. All this is best illustrated through examples (see below).
One important thing to consider is there are also two styles of options, an American-style contract and a European-style contract. An American-style contract lets you exercise the contract at any time before expiry whereas a European style contract only exercises at expiry. In the examples below we are assuming the contracts are American-style as most are, and we are exercising them early to realise our profits.
Call Contract Example
Say you purchase a call contract on company X with the strike price of $100 and an expiry date three weeks away. You pay a premium of $2 for the contract and it has a multiplier of 100. This means you have the right to buy 100 shares of company X at anytime in the next 3 weeks for $100 per share. And for this right you payed a $2 per share costing you a total premium of $200. Imagine the price of company X is $90 when you buy the contract but sometime in the next 3 weeks the price of company X rises to $120.
Now if you choose to exercise the contract you can buy 100 shares of company X at $100 and instantly sell it on the market for $120 making you $20 per share. This gives you a total profit of $2000 minus the $200 you paid for the contract giving you a $1800 dollar profit on a $200 investment. A return on investment of 900%.
Compare this to a scenario where instead of buying the call you bought 100 shares of company X at $90. You make a profit of $30 per share giving you a profit of $3000 dollars on an investment of $9000. This is a return on investment of 33% compared to the 900% return on investment for the call. For the $9000 you spent on shares you could have bought 45 calls and made a profit of $81,000. This is obviously an extreme in which a company rises 33% in price in under 3 weeks. However it illustrates the massive difference in potential upside.
In another scenario where company X does not reach a price of $100 within the 3 weeks until expiry the call becomes worthless and the buyer loses the $200 invested. Or $9000 if they were crazy enough to go all in with options. Whereas the shareholder still has 100 shares at whatever price company X now trades at.
Put Contract Example
Lets work with a similar scenario to the one above but this time company X is trading at $110 and you think it is overvalued and set for an extreme short term correction. You manage to buy a put on company X with a strike price of $100 and an expiry date three weeks away. You again pay a premium $2 per share and the multiplier is 100. This gives you the right to sell 100 shares of company X at $100 per share to the person who sold you the contract. And for this right you pay $200 ($2 premium x 100 shares).
Now if the price of company X falls to $80 you can exercise the put by buying 100 shares of company X for $80 each and selling them for $100 each. Giving you a profit of $2000 minus the $200 you paid for the contract. This is again a $1800 profit on a $200 investment, this time betting that the price of company X would fall below $100 within the next three weeks.
Things to consider
Most contracts expire out of the money – four out of five option contracts never go past the strike price. And many of those that do, don’t make insane returns like the examples above.
You don’t have to exercise the contract – Options are traded on the market and you can sell any contract you bought right back into the market. You could buy a contract for a premium of $2 and sell it for a premium of $3 making 50% returns. Or you can sell it for a lower premium when you no longer believe it will reach the strike price and you can save yourself a complete loss of holding it until expiry.
You can’t exercise a contract without the money to buy the shares – If you have a call giving you the right to buy 100 shares at $100 dollars and you want to exercise it to sell those 100 shares for the new now higher market value. You will still need the $10000 to buy the 100 shares in order to make your profit. If you don’t have the capital for that you can always sell the contract back into the market for a now much higher premium. Which will bank you a nice profit as well.
What if I hold until expiry? On expiry your contract automatically exercises if its passed the strike price and now in the money. Or if it hasn’t reached the strike price it then just expires worthless. In the case of holding until expiry you have to make sure you have the necessary cash or margin requirements to exercise the contract.
Where can I buy options? – You will have to sign up to a brokerage that lets you buy options. Different brokerages come with different commission fees and requirements to trade options, so you can do your research and decide what’s best for you. Also they will have levelled access for trading options in which case you may be limited in how you can trade options. Many may only allow you to buy options and not sell them etc…
Can I trade American style options outside of the U.S? Yes, there are many brokers outside of the U.S that will let you trade American-style options on a variety of stocks both in and outside the U.S market.