Covered Calls and Poor Man's Covered Calls on Robinhood
Options Trading Basics
What Are Options?
An option is a contract. It gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Think of it like a coupon for a stock. You can buy a coupon that lets you purchase a product at a fixed price for the next month. If the product's price goes up, your coupon is valuable. If the price goes down, you can just let the coupon expire and you've only lost the small amount you paid for it.
Think of options as an agreement, a contract giving you the right, but not the obligation, to buy or sell an underlying asset...at a predetermined price (called the strike price) on or before a specific date (the expiration date).
The "underlying asset" is usually shares of a stock, like Apple or Tesla. Options trading is essentially making bets on the future price of that stock.
The Two Types of Options
There are two basic types of options: calls and puts. They are opposites.
A call option gives you the right to buy a stock at a set price. You buy calls when you think the stock's price is going to go up.
A put option gives you the right to sell a stock at a set price. You buy puts when you believe the stock's price is going to go down.
Calls are for when you're bullish (expecting a price increase). Puts are for when you're bearish (expecting a price decrease).
Let's say TechCorp stock is trading at $100 per share. You believe it's going to rise to $120 in the next month. You could buy a call option that gives you the right to buy 100 shares of TechCorp at $105 anytime in the next 30 days. If the stock does rise to $120, you can use your option to buy the shares at $105 and immediately sell them for $120, making a profit.
Conversely, if you thought TechCorp was going to fall to $80, you could buy a put option. This would give you the right to sell 100 shares at, say, $95. If the stock drops to $80, your right to sell at $95 becomes very valuable.
| Option Type | Your Belief | Your Right |
|---|---|---|
| Call Option | Stock price will go up | To buy the stock |
| Put Option | Stock price will go down | To sell the stock |
Anatomy of an Options Contract
Every options contract has three key components you need to know.
Strike Price
noun
The set price at which you can buy (for a call) or sell (for a put) the underlying stock. It's the price your contract is built around.
In our TechCorp example, the strike prices were $105 for the call and $95 for the put.
Expiration Date
noun
The date on which the options contract becomes void. You must use your option on or before this date, or it expires worthless.
Options can have expirations ranging from a few days to a couple of years.
Premium
noun
The price you pay to buy an options contract. It's the cost of securing the right to buy or sell the stock.
The premium is determined by factors like the stock's current price, the strike price, how much time is left until expiration, and the stock's volatility. The buyer pays the premium to the seller of the contract.
Rights vs Obligations
This is a crucial concept in options. For every options contract, there is a buyer and a seller (also called a "writer"). Their roles are fundamentally different.
The buyer of an option pays the premium and gets the right to exercise the contract. The most they can lose is the premium they paid. Their potential profit can be substantial.
The seller (or writer) of an option receives the premium and has the obligation to fulfill the contract if the buyer decides to exercise it. This means they must sell their shares (for a call) or buy shares (for a put) at the strike price. They keep the premium no matter what, but their potential losses can be large if the stock moves against them.
Buyers have rights. Sellers have obligations.
Understanding these core ideas is the first step. You now have the basic vocabulary for how options work. Let's test your knowledge.
An options contract gives the buyer the _______, but not the _______, to buy or sell an underlying asset at a set price.
If you believe the price of a stock is going to decrease, which type of option would you buy to potentially profit from this movement?