Options Trading with Vector Analysis
Options Basics
What Are Options?
Imagine you hear a rumor that your favorite band might have a surprise guest at their next concert. You can buy a voucher that lets you purchase a ticket for $100 anytime in the next month. You pay $5 for this voucher.
If the surprise guest is announced and ticket prices jump to $200, your voucher is a great deal. You can buy the ticket for $100, saving you money. If the rumor is false and ticket prices drop, you can just let the voucher expire. You only lose the $5 you paid for it.
An options contract works in a similar way. It's an agreement that gives you the right, but not the obligation, to buy or sell an asset at a set price on or before a certain date.
Every options trade has two sides: a buyer and a seller. The buyer pays for the rights the contract provides. The seller, also called the writer, receives that payment and is obligated to fulfill their side of the deal if the buyer decides to exercise their right.
The Building Blocks
Every options contract is defined by a few key terms. Understanding them is essential to understanding the option itself.
Strike Price
noun
The set price at which the underlying asset can be bought or sold. In our concert example, this was $100.
The strike price is the anchor for the entire contract. It's the price that determines whether the option is profitable for the buyer to use.
Expiration Date
noun
The date on which the options contract becomes void. The buyer must exercise their right on or before this date.
After the expiration date, the option is worthless. Time is a critical factor in options trading.
Premium
noun
The price of the options contract itself. The buyer pays the premium to the seller to acquire the rights of the contract.
The premium is the maximum amount of money the option buyer can lose. For the seller, the premium is the maximum profit they can make from the sale of the contract.
Calls and Puts
Options come in two basic flavors: calls and puts. They are mirror images of each other.
A call option gives the buyer the right to buy an asset at the strike price.
You would buy a call option if you believe the price of the underlying asset is going to rise. This is known as a bullish position. For instance, if a stock is trading at $45, you might buy a call option with a $50 strike price. If the stock soars to $60, your right to buy it at $50 is valuable.
The seller of the call option has the opposite view. They believe the price will stay below the strike price. They collect the premium, hoping the option expires worthless.
A put option gives the buyer the right to sell an asset at the strike price.
You would buy a put option if you believe the price of the asset is going to fall. This is a bearish position. Let's say a stock is at $45. You buy a put option with a $40 strike price. If the stock price plummets to $30, your right to sell it for $40 becomes profitable.
The seller of the put option believes the stock price will remain above the strike price. They collect the premium, betting that the buyer won't have a reason to exercise the option.
| Option Type | Buyer's Right | Buyer's View | Seller's Obligation | Seller's View |
|---|---|---|---|---|
| Call Option | Right to BUY | Bullish (Price will rise) | Obligation to SELL | Neutral to Bearish |
| Put Option | Right to SELL | Bearish (Price will fall) | Obligation to BUY | Neutral to Bullish |
Ready to check your understanding? Let's review these core concepts.
What does an options contract grant the buyer?
An investor who believes the price of a particular stock will decrease in the near future would take a _______ position by buying a _______ option.
That's the foundation of options. Every strategy, no matter how complex, is built from these simple building blocks: calls, puts, strike prices, expiration dates, and premiums.