An option is a contract that gives the buyer the right (not the obligation) to purchase or sell stock at a set price in a certain time-frame.
At any time during the time-frame, an American Option can be exercised; a European option can only be exercised at the expiration date.
A single contract is usually comprised of 100 shares.
This means if you buy a contract priced at 1$ your actual price will be 100$ (plus any commission or fees but for this article we will ignore any fees).
In a hypothetical example, let’s say the buyer purchases an option for 1$ with a strike price of 10$.
This transaction would cost the buyer 100$ (100 shares* 1$).
Let’s assume the stock goes to 12$ at expiration.
The buyer at expiration would net a profit of the value of the option at expiration (2$*100 shares) -100$ initial investment for a profit of 100$ or a 100% return.
If the stock were to never go above the strike price, the buyer would only lose the price payed for the option contract up front (100$).
This minimizes risk.
The max downside of purchasing this option contract is 100$.
The maximum downside of purchasing 100 shares outright is the full price of the stock*100 shares.
For an option, the max downside is only the option premium.
The above example was a Call Option; a Call Option has a bullish outlook while a Put Option would work exactly opposite to the Call Option and represent a bearish outlook.
A bullish outlook believes the stock price will go up.
A bearish view believes the stock price will go down.
Calls and Puts can be purchased depending on market outlook.
And options can be purchased in many different combinations to take advantage of factors like volatility or lack thereof.
For Calls and Puts there are 3 different scenarios when considering the types of calls or puts you’re looking to purchase: In The Money (ITM), At The Money (ATM), and Out of The Money (OTM).
A Call Option is ITM if the strike price of that option is less than the current price of the underlying stock.
A Call Option with a strike price of 20 is considered ITM if the underlying stock is priced above 20.
An ATM option is one with the same strike price as spot price.
And OTM is the opposite of ITM; OTM options have a strike price less than the underlying stock price (spot price).
(If you didn’t like my explanation for the basics of options you can find further explanation at Investopedia before continuing to the visualizations)Visualizing CallsLet’s visualize each and maybe it will make more sense.
For our visualization we use Bokeh and a data set of historical prices for Apple.
We are visualizing profits based on profit at exercise.
Comparing Call OptionsThe first visualization showcases buying a Call Option.
If we simply want to buy a Call Option we need to make a choice: do we want to buy OTM, ITM, or ATM?.The above graph showcases the payout profile for each scenario.
You can make some interesting observations from the graph.
As you can see, buying OTM Calls is much cheaper as you buy strike prices further from the underlying stock price.
However, with OTM Calls, the stock price must rise more than ATM and ITM Calls before we can start profiting from the hockey stick.
ITM Calls naturally cost more but we begin to profit much sooner from the purchase of ITM Calls.
Each choice (ITM, ATM, OTM) has its own unique characteristics and situations where it is useful.
Visualizing PutsLet’s Check out what Put Options look like.
Comparing Put OptionsAs you can see, Put Options display the exact opposite characteristics of Call Options.
Puts showcase the same sort of hockey stick formation but in the opposite direction.
The purchaser of a Put Option pays the premium up front and profits as the underlying stock goes below the strike price.
We see that Put Options function opposite to Call Options.
By combining the purchase of Call and Put Options in various ways we can create unique positions.
There are many more complex option strategies available.
We’ll cover two of the simpler strategies: straddle and strangle.
Some More Advanced StrategiesLong Straddle: Profiting Off VolatilityThe above graph showcases the straddle.
A straddle is created by purchasing options of the same stock, with the same strike price and expiration date.
A straddle position profits if the underlying stock moves far enough in either direction.
This means a straddle position is market neutral.
Trader of a straddle believes the stock is bound to move a lot but isn’t sure in which direction.
This strategy is popular for stocks that have historically been very volatile or stocks with important upcoming events.
Earnings, clinical trial results, and many other events can be catalysts for stocks to move.
In the case of pharmaceutical companies depending on R&D to drive earnings, clinical results generally can swing a stock price significantly.
If a trader does not have an opinion on the upcoming trial results or doesn’t feel comfortable picking a side, that trader can profit from volatility by taking a straddle position.
Taking Advantage of Volatility but with a Biased ViewLet’s say we believe the stock is heading in a certain direction but also want to profit (or protect downside) off the stock heading in the opposite direction of where we think it’s headed.
This position is like a straddle in that it profits off volatility.
But it is different in that it is biased in one direction.
In the above strangle it is biased long as the Call Option is purchased ATM and the Put Option is purchased OTM.
It is easier in this situation to profit off an upward move.
If our market view is horribly wrong and the stock tanks, our downside risk is protected by the OTM Put.
If the underlying stock moves way down we can still profit from this position as the graph represents.
There are many different options strategies available: Bear Spreads, Bull Spreads, Condor Spreads, Butterfly Spreads, Ratio Spreads, Covered Calls, etc.
The advanced trader will learn these different strategies and apply them accordingly.
Understanding different strategies allows the trader to trade with more sophistication and take advantage of more opportunities.
In a later article we’ll cover some of the more advanced options strategies.
For now, you can find the code for the above examples on Github.
As mentioned at the beginning: nothing in this article is meant to be investment advice or is guaranteed in any way to be correct or usable investing information.
Please do your own research and consult a licensed professional.