Options for everybody

2.3 Buying or selling Options?

You have already gained a first insight into the world of options, the first types of contracts and what they contain. Now it's time to increase the speed a bit and deal with the really serious topics. Don't worry, everything will be explained to you in detail again and if you don't understand it on the first try, go back and take the time to go through the lines again. Remember: option trading is a marathon, not a sprint.

You have already learned that you can act as an option buyer. Logically, however, there must also be an opposing side, which you can of course take too. Let's start with a small table - this will make it clearer and easier to understand which rights and obligations we need to know as traders when it comes to buying or selling calls and puts. Remember that every trade has two sides. So you always have an opponent with whom you have to agree to trade. There are four basic options we can get involved with. We can buy calls and puts or sell calls and puts.

Figure

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: Rights and obligations for buyers and sellers

In this case, the buyer of a call option has the right to buy the share at a certain price in the future. If you are now an option buyer, you pay money in the form of a premium. So if you pay for something, in return you get a right to make a decision in the future, to wanting to exercise an option or not. On the other hand, a put option buyer has the right to sell shares at a certain price in the future. In both cases, you pay money to the option seller so that you acquire a right and at the same time commit the counterparty.

On the other side of the table we have the option sellers. As option sellers, we have obligations because we have sold our rights for a fixed premium. As a seller you are obliged to sell or purchase shares at a certain price in the future. However, this only applies if the other party makes use of its right and you have to fulfil your obligation. In this case one speaks of being "assigned". But what is my advantage in selling rights if I can be assigned at any time during the contract term? We will discuss this in detail and at the end you will notice that the option seller's side is much more profitable and comfortable than the buyer's side.

For example, you have the option to conclude the option contract at any time, which will liquidate your obligation. I'll be a little ahead of you here. Let's say you're a seller, your option has already made 50% profit, so you buy back your own contract, which is worth much less than it used to be, of course. You keep the 50% of the premium and at the same time your obligation is released. Basically you have a lot of possibilities to manage your contracts in order not to be committed. You will get to know them all in the course of the book.

The obligation to buy/sell shares is only given if they expire or if they are assigned early. However, early assignment of your position only works for American-style options. In contrast, there are still so-called European options, which cannot be managed/closed or assigned during the contract period. With this type of option, the entire term is binding for both parties to the contract. However, these are of no interest to us and are therefore ignored. But now we want to take away your fear of being assigned. You don't have to panic to owe your counterpart 100 shares once. Assignments usually happen within the last week or the last few days of a contract term. However, we have sufficient possibilities to manage our contracts in advance so as not to let it get that far in the first place - you are going to learn these mechanics later.

Let's get back to the basics. As a seller, you now have an obligation. In the case of a put option, you have the obligation to buy shares from the option buyer, who will sell them to you at a predetermined price (strike). So if the put option buyer says that he will sell a stock to you at USD 50, you must buy the stock for USD 50 if the price has fallen to that price. If the stock continues to fall, you still have to pay the counterparty the agreed price (strike), even if the stocks are actually only worth USD 30, for example. Your intention as an option seller is, of course, that the stock remains worth more and does not fall to this level. In this case, the seller now receives money from the option buyer in the form of a premium. Do you remember? As a buyer you always had to pay this premium, as a seller you collect it immediately at the beginning of the contract.

Let's repeat what we've said. If you are a call option buyer, you hope in this case that the stock price will rise. This is your hope. You buy a call option in the expectation that the stock price will rise in the future. If you are a put option buyer, you hope the stock price will fall below your strike. When buying a call or put option, remember that you pay a premium to get a right. You are dependent on the stock not only moving, but also on your preferred bill. Otherwise you not only lose the premium, you also make no profit. By claiming this premium as a seller, you give yourself the rights to commit yourself. However, you don't care what the share does. It can rise, fall or simply not move at all. As long as your strike price is not reached, you keep the premium.

So as option sellers, we have more opportunities to make money than we have as buyers. This will become particularly clear in the course of the book. We have not yet talked about what it looks like as a seller with profits and losses. As you probably already suspect, the distribution in this case is exactly the other way around. As a seller, you cannot earn more than the premium received, but you can lose significantly more. But don't worry, we'll take care of it so that this doesn't happen. First of all, it is important that you understand the profit/loss charts. These are essential because each strategy offers you different graphs. So you have to understand the basics once, after that everything is as good as self-explanatory.

Remember:

There are four basic option contracts (long or short / calls and puts).

As a buyer you acquire a right, but as a seller you commit yourself.

As a seller you have many possibilities to manage profits and losses in order to be profitable in the long run.

As a seller of puts, you have to buy shares at a certain price (strike).

As a seller of calls, you must deliver shares at a certain price (strike).

2.4 Profit  Loss

(PL) Diagrams

It is really essential to understand profit/loss (P/L) diagrams, because they are the key element in understanding where to make money, where to break even, and where and how far the loss zone extends. It is important to understand how they work because they can help you understand complex strategies and how to apply them to the underlying.

Figure

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: P/L-Diagram (Long-Call)

Here you can see a basic P/L diagram, which can be applied to all strategies accordingly. On the Y-axis you see a straight line, where everything above 0 represents a profit and everything below 0 represents a loss. The X-axis represents the price of the underlying. The break even is the point at which the chart moves from a loss to a profit zone.

Ultimately, this means nothing more than a representation of where the price of the underlying stock must be on the expiration date for you to be profitable. That's basically what we're looking at. The bluish line represents the strategy. Different strategies of course have different charts, because they are profitable at different times, or contain a limitation of the potential loss or not. In the course of this book you will see many more such graphs. Just when I teach you the individual strategies, they play an overriding role.

The example above represents a call option. You start in a negative area because you have paid a certain premium. Remember, you can't lose more than this. You will also see the strike price, which is the price at which you bought the option. As soon as this is reached, the graph starts to rise and finally reaches the break even. Remember, this is always higher than your strike in a call, because you have to calculate strike + premium paid. As soon as this value is exceeded, you start to run into the profit zone.

Figure

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: P/L-Diagram (Short-Call)

Let's look at another example. In this case it is a short call. As you can see, the potential profit is limited, but the risk is unlimited. Also note that this time the break even will play in your favor. To calculate this, you take again the strike price + premium taken. Only if this point is exceeded and the stock continues to rise, you begin to enter the loss zone. On the other hand, it is irrelevant how far the stock falls below your strike. You will never earn more than the premium earned, but you have unlimited risk "downwards".

Let's look at a more complex strategy - the Iron Condor.

Figure

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: P/L-Diagram (Iron Condor)

In this case, we benefit if the share moves within a defined corridor. It is completely irrelevant whether it is at the upper or lower limit on expiration date. You will be allowed to keep the premium in any case. This is a great example of non-directional trading, as you don't have to have an opinion about the further course of the stock. To put it bluntly, you don't care whether it rises or falls as long as it stays within a certain fixed corridor. You also see the break even points and that you have a built-in loss limit. You can't lose more than the previously set amount. Yes, this is also possible with options.

But before this becomes too much for you, we will stop at this point. Strategies will be discussed later. The most important thing was to understand what P/L diagrams are made of and how to read them.

Remember:

P/L diagrams always consist of several components.

Profit/loss zone, strategy, strike price(s), break even(s).

They allow you to get a visual idea of the current strategy - "what happens at what point".

2.5 Repitition: Understanding Call Options

At this point we would like to repeat the essential components. Before you groan bored, it's fast and important. The basics really have to sit - just like in school. Every strategy in the options area consists of calls, puts or a combination of both. It is therefore of the utmost importance to master them. So let's go over what we've learned.

In the last sections, you learned that a stock option is actually just a contract to buy or sell shares at a fixed price for a limited period of time. The fixed time is called the expiration, and the fixed price is called the strike. One of the most important things to remember about options is that 1 contract represents 100 shares. So if you sell an option contract for 1.00 USD premium, that's actually 1.00 USD per share, so a total of 100 USD premium. An option contract of 0.50 USD costs 50 USD as buyer or brings you 50 USD as seller. Each option has its own price, which is derived from the Black-Scholes option price model. Black and Scholes received the Nobel Prize for it, but I'm not going to torture you with this formula now. More important is that you understand the ingredients and their effects. Memorizing formulas is only for know-it-alls (and students - we all had to go through that). The most important factors affecting option prices are the stock price and the time remaining before the option expires and volatility. For this reason, the options market is a derivative market for the actual share. However, other factors such as gamma play a role, but we will discuss these components later.

A call option is a contract that you can purchase. With this purchase, you can buy 100 shares at the predetermined strike price at the end of the contract. Just like a stock, you can also sell a call, obliging you to provide 100 shares at the end of the contract and at the chosen strike price if the stock price is above the chosen strike price.

If you own a call and the stock price is above the strike price, the value of the call also increases - it now has a higher value than before because you could buy the stock at a discount (the strike price). If the stock falls below your strike price, the value of the call option also drops. Why should anyone buy shares at a higher price than what the market is currently offering? Answer: Nobody would! If you have a call, you don't have to buy the stock before the contract expires. You could close the position and take the profit/loss without taking ownership of the stock. You could also choose to exercise the option and acquire ownership of the stock at the strike price at which the call was bought if the stock price is above your strike price. In principle, however, as a buyer you are not obliged to any activity, you can also wait and do nothing.

If you make a short call, you are obliged to provide 100 shares at the request of the buyer if the share price is above your strike. However, there are measures you can take to prevent this. Before the expiry, you have the right to close the position prematurely and realise the profit/loss you have achieved, just like with a long call. Detailed explanations will of course follow throughout the book.

Of the four basic option transactions (long call, short call, long put and short put), the call option is the one that comes closest to buying 100 shares. This is due to the fact that you benefit from an increase in the share price, just like pure shares, and you have unlimited profit potential at the same time. The call buyer is "long" because he expects to sell the option later at a higher price. When you buy a long call, you pay a premium to open the position. To benefit from this, you must be right in your assumption of rising prices before the contract expires and the option must be worth more than the premium you paid for it. The maximum loss is the premium paid, the potential profit is unlimited.

Remember that the buyer of a long call wants the price of the option and the stock to rise. When we sell a call, the call is "short", so we take the other side of the transaction and want the value of the call to go down. The biggest advantage of the short side is that we don't necessarily need the stock price to be profitable until the expiration date. The stock price can fall, stay the same or even rise a little as long as it is not above our strike when it expires.

That sounds complicated, but it's not. This approach is very similar to that of an insurance agency. When you sell a call, you are betting that the stock price will not reach your strike until it expires. Insurance agencies and casinos live from the fact that they do NOT pay out more than they earn and their insurance premiums and gambling opportunities are prepared to ensure that this happens in the long run.

2.6 Repitition: Understanding Put Options

In the previous section you learned that call options theoretically correspond to 100 long shares for the call holder and 100 short shares for the call seller. A put contract is exactly the opposite. Instead of buying a call up, investors usually buy puts to speculate down, or rather to hedge stock positions! Put options are similar to call options in the sense that they are the theoretical equivalent of 100 shares, but put options let the owner sell the shares at a fixed price for a limited period rather than buy them. So you can buy puts to hedge against falling prices, for example, because you could sell your shares for more than the current price.

If you have a put and the price of a share falls below the strike price you have chosen, you have the right to sell shares at a higher price than the current share price. Many investors regard put contracts as a form of "protection" or insurance against shares already held, as they allow them to secure a selling price for their 100 or more shares. However, this is not free of charge, as the purchase of this insurance costs something, of course. For many people, put options are nothing more than insurance contracts - just like you buy insurance for your car. You pay a premium for this, but you remain hopeful that you will never have to make actual use of this contract.

If the share price rises, the value of the put option decreases. If the stock price at expiration is above the put option, the put contract is worthless because investors could sell shares at a higher price in the market compared to the put strike. Why should anyone sell shares at a lower price than what the market offers? For the same reason, investors would not buy stocks with their call if the call was at a higher strike price than the stock. Just like call options, there are other factors that affect the price of a put option, but from a direct point of view, a put contract works like a call contract.

Just like stock and call options, I can buy or sell a put option. When I buy a put option, I have the right to sell 100 shares at the strike price I have chosen. The put has a real value if the stock price at expiration is below the strike price because it gives me the opportunity to sell shares at a higher price than the stock price. As with long call options, my long put must have a higher value than I paid in advance to be profitable at expiration. This means that we need a directional downward movement to be profitable on expiration with long put options, regardless of where the strike is at the time of purchase.

If a stock is 50 USD and I buy a long put with strike 50 USD for 1 USD, the stock price at maturity must be less than 49 USD in order to make a profit. If the stock price at expiration is 48 USD, my option would have a value of 2 USD and I would make a profit of 1 USD or 100% on the contract because I bought it for 1 USD and sold it for 2 USD. However, if the stock is at USD 50 at expiration, I would lose a premium of USD 1 because the option has no "real" value and investors can now sell stocks in the market at the same price as my strike. We pay an unscheduled value for the right to own the contract, and we have to offset that val