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What is an Option?


What is an Option?

If you've traded stocks, there's a good chance you're at least familiar with the concept of trading options. But there's also a good chance you're not sure what that means.

Options are a complex subject but with the help of the following infographic, you should develop a basic understanding that makes them more approachable. You'll learn about the basic components of the two types of options contracts - calls and puts - and why you would want to incorporate them into your trade plan. You’ll also see examples of how market movement could affect various options strategies for a clear look at both the pros and cons of options trading.

For more information on trading options with Schwab, speak with a Schwab specialist anytime at 888-245-6864.


What is an Option?

If you've ever researched options, you may have come across a definition along these lines: An option gives you the right to buy or sell an asset at an agreed upon price for a specific period of time.

But what exactly does that mean?
To explain, let’s take a trip to the market...

Just like a grocery store sells different food items for different prices,
the markets are filled with different products selling for different prices.

There are two types
of options contracts:

Calls

Puts

The primary difference is that calls are for buying while puts are for selling.

They are both represented by symbols that provide you with the details.

Click on each box to see corresponding symbol component.

Option type

This letter, either a “C” or “P”, indicates whether it is a call or put.

Underlying asset

This is the security/asset the option allows you to purchase or sell.

Expiration date

If an option is not exercised or closed out by the expiration date, it (of course) expires.

Strike price

This is the price at which you can buy or sell the shares.

*Quantity: All standard options contracts
are for 100 shares of the underlying asset.

We’ll start with call options,
which you can think of as a coupon that you buy.

GROCERY COUPON

This grocery coupon gives you the right to buy
- a specific quantity...
- of a specific product...
- at a specific price...
- for a specific period of time.

OPTIONS CALL CONTRACT

This call option contract gives you the right to buy
- a specific quantity...
- of a specific underlying asset ...
- at a specific price...
- for a specific period of time.

Let's say you're bullish on a stock.

You buy a call option with a $10 strike price at $2 per option.

Since each contract represents 100 shares of stock, the total cost for one call option contract is $200.

*How much do options cost?
There are a variety of factors that determine the price of an option. For the examples that follow, we’ll be using hypothetical options prices for simplicity.

Turns out you were right and the stock price rises from
$10 to $15/share.

You exercise your call and buy 100 shares of the stock at the strike price of $10.

$10 per share
times 100 shares
?
Cost of call contract
?

You now have spent $1,200: $1,000 to buy the stock and $200 to buy the call option.

You can immediately sell those shares at the market value of

$15/share

for a total profit of

$300

$1,500

Amount you sold your shares for
?

- $1,200

Cost of shares ($1000) + cost of call ($200)
?

$

Now let’s take a look at put options

Puts are typically purchased as a form of protection against undesired market movement, similar to auto insurance policies purchased to cover accidental damage.

INSURANCE POLICY

This insurance policy ensures—for a certain amount of time—that you receive a certain amount for your car, regardless of its current resale value.

PUT CONTRACT

Similarly, this put contract allows—for a certain amount of time—that you receive a certain amount for your shares, regardless of their current market value.

Let’s say you’re bullish on a stock.

You buy 100 shares at $50/share.

[$50 x 100 = $5,000]

Despite your bullish outlook, you want to protect yourself in case the price declines.

So, you buy a put option with a $48 strike price for $200.

The stock declines from $50 to $30/share.

You exercise the put and sell the 100 shares of the stock you own at $48/share, instead of at the market value of $30.

By “insuring” your long stock position with a put, you only lost $400 instead of $2000.

Original investment in the stock
?
Cost of the
put contract
?
Amount you sold your shares for when you exercised your put at the strike price of $48/share
?
..............................................................................................................................................
Original investment in the stock
?
Amount you sold your shares for at market value of $30/share
?

You sell your shares for $6,000, $1,000 more than you paid for them.

..............................................................................................................................................

The $200 cost of the unexercised put contract cuts into your profit—essentially the cost of being “insured”—for a total profit of $800.

..............................................................................................................................................
Original investment in the stock
?
Amount you sold your 100 shares for at $60/share
?
Cost of unexercised put contract
?

Three outcomes of an options contract

Once you buy an options contract, there are three different things you can do with it:

Excercise It

click to see
more info

Sell It

click to see
more info

Let It
Expire

click to see
more info

X

Excercise it: Exercising a call allows you to buy the underlying security; exercising a put allows you to sell it.

We looked at two examples of when you would exercise an option contract, which usually occurs at or around expiration.

Call – Exercise the call when the strike price is below the current market price of the underlying stock.

Put – Exercise the put when the strike price is above the current market price of the underlying stock.

X

Sell it: Just like you can sell a stock, you can also sell an option contract if you decide you don’t want it anymore or if your outlook on the stock changes.

One reason to sell your option would be to allocate the capital on a different opportunity:

- You think XYZ will trade up from $20/share to $25/share so you buy a call with a $21 strike price
hoping to profit.
- XYZ continues to perform strongly as you approach expiration, but you become more interested
in a new trade opportunity.
- The price of your call option has risen due to a rise in the price of XYZ stock, and you are able to sell it on the open market for $250, trading capital you can allocate to the new opportunity instead.

X

Let it expire: If the stock is trading above your call strike price (or below your put strike price) then it will be automatically exercised for you if you don’t take any action by the expiration date. If the stock is trading below your call price (or above your put strike price) at expiration then it will expire worthless.

The most common reason for letting an option expire would be that you bought a protective put but your position didn’t move against you.

- You own XYZ but decide to protect yourself from a move against you with a put contract.
- XYZ continues to perform strongly, increasing the value of your shares but decreasing the value
of your put contract.
- The put continues to lose value until it eventually expires worthless. You’ve lost the cost of the contract but, in this instance, your shares have gained value themselves.

DISCLOSURE

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options.

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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