I've recently started learning about the world of stocks and trading. Currently I'm trying to understand better how option trades work and would be very grateful if you can help. Please be as detailed, yet simple as possible with your corrections and answers. THANKS IN ADVANCE!! SCENARIO: (Call) I am considering Options Trading to generate income. I see the stock price for XYZ is at $6/share; Contract A has 100 XYZ shares at a strike price of $5/share and a Premium of $3/share with 3 weeks left before the contract expires. I Call an option with 3 weeks left until the contract expires. The total premium for the 100 shares would be $300. The Intrinsic Value would be the profit when I exercise so buying 100 shares at $5 each and selling at stock market price of $6 each would result in $1 profit per share. The Extrinsic Value, however, would be the difference between the premium and IV which results in $2 per share. This would be the value given to the option because there’s 3 weeks left to maturity. Spoiler: Question Set 1 · What I’m buying when calling an option is contract itself rather than the shares? · Since I still have 3 weeks left until the contract expires, when exactly do I pay the premium and buy the 100 shares? Is it on or before the expiration date for both premium and strike price? · Since I still have 3 weeks left until the contract expires and I don’t want to pay a total of $300 (premium) + $500 (shares) = $800, can I sell this contract before it expires? FOLLOW-UP SCENARIO: (Put) There are 2 weeks left in the contract before expiration and the stock price for XYZ went up to $7/share. Since I called the option, I am now the new owner of the contract. I decide to sell or put the same options contract at a strike price of $6/share. The premium is now $4/share. The premium price is determined by supply & demand, among other factors (?). Once the option I put is called, I am no longer the owner of that contract and generated a profit. Expiration Date: 3 weeks to 2 weeks Stock Price: $6 to $7 per share Strike Price: $5 to $6 per share Premium Price: $3 to $4 per share Spoiler: Question Set 2 · Where does the net profit come from? Premium price change or strike price change from calling/putting? · Does putting an option extend the expiration date of the contract or it remains the same? · Who decides the expiration date? Is it the original seller? · Does the seller decide the strike price? What exactly determines these prices? Spoiler: Additional Questions · What exactly does exercise an option mean? · Does calling/putting an option mean you automatically exercised the option? · Is the maturity date the date the option/contract expires? · Can multiple people call/put or exercise the same option? TAKEAWAYS: (Correct if wrong) - Essentially, in options trading, my profit (or losses) would come from research, analysis, experience and speculation. I buy/call the option at one price and sell/put the option at a new price. - If I complete all transactions before expiration date, I never really buy the 100 shares, so I don’t pay for those. The money I’m investing is only the premium price for calling the initial option. - If I can’t get someone to buy my options contract by expiration, I might be at a huge loss because I had to pay a premium plus the strike price for each of the 100 shares.
I think this is gonna be easier to digest if I go straight to your questions. When you buy an option contract you are, yes, buying a contract. The contract is either a Call or a Put. One contract is typically the equivalent of 100 shares. The premium of the option contract is the current market price. So if the premium of a Call contract is currently $3.00, then when you purchase the Call you invest $300.00 in it. You now own a Call contract and you do not own any shares, nor are you obligated to own any shares. In fact, if you buy a Call (or a Put) and then do nothing at all (meaning either sell the contract or exercise the contract) you will end up with nothing when the contract expires. The good news is, most options get settled at expiration automatically, so if you did not sell the option, your broker will essentially exercise it. Most experienced option traders do not exercise their long options...rather, they do as you suggest: they sell it. Sometimes for a loss, sometimes for a gain. You can sell any options you are long in (that is, that you own) any time before expiration. Think of options contracts the same as a stock. They have a total value that changes when the price of the underlying stock goes up and down. Time value and intrinsic value of course are the 2 primary components of this total value, but suffice to say that as the underlying stock prices changes so too do the related options associated with that stock. Nothing extends the expiration date of a contract. It is a set, finite date. Buyers and sellers do no decide the expiration date any more than you buying a carton of milk changes the expiration date of the milk. Buyers and sellers simply select options at whatever expiration date suits their investing style/thesis. Ultimately, the US Securities and Exchange Commission plays traffic cop in approving expiration dates. Their main role is to ascertain liquidity, and to ensure there is an orderly rollout of option expiration dates on offer, roughly equivalent to a third of all monthly option contracts offered each month of the quarter. The strike price is like the expiration date. Buyers and sellers select a strike price that fits their investing style/thesis. Ultimately, the market makers decide which strike prices are offered. If you own a Call and you exercise, you are calling away 100 shares per contract at the strike price. You tell your broker, they find the hundred shares somewhere, and then sell them to you at the strike price. If you own a Put and you exercise, you are putting 100 shares to somebody. You tell your broker, and they buy the shares from you at the strike price and find somebody somewhere to take those shares at that price. Now, if you are short a Call or Put (that is, you sold a Call or Put without previously owning it) and the owner of that Call or Put decides to exercise, you are then "assigned", which means your broker sticks you with 100 shares per contract at the strike price, or takes away shares you own and pays you at the strike price. Nope. For starters, you really don't "call" or "put" an option. You buy or sell Calls and Puts. You can exercise options (Calls or Puts) you own, which then allow you to "call" shares away from someone, or "put" shares you already own to someone. Yep, same thing, although "maturity date" vernacular is rarely used. When you look at an options table and you see a column for "Volume" that is the number of contracts traded at that strike and expiration on that day. You'll also see an "open interest", which is the number of open contracts at that strike and expiration. Some of your takeaways are a little off. In your first takeaway, it appears you are conflating buying and calling an option as one thing, and then selling and putting an option as another mutually exclusive thing. That is not quite right. You can go long (buy) Calls and you can buy Puts, and you can go short (sell) Calls and Puts. Your second takeaway is fairly accurate. The third takeaway needs a little clarification. You don't have to worry about someone buying your option contract by expiration. You can sell your option contract at any time. The option table will show you a bid and ask price, and when you are ready to sell you can put in an order (I usually split the bid-ask price) and see if the market maker takes your offer or (more likely) drops the ask to get you to sell it for less. There is almost always a market for your option before expiration, although you may not like the price you can get. Hope all this helps!
