What Are Options? Choices and Contracts
The word “option” brings up the reality of choice. Option means choosing or the freedom and power to choose. If I have options, I have choices. Sometimes choosing is difficult and the wrong choice can result in loss or catastrophe. When people hear the word “options” joined with “stocks” the result is “stock options.” This sounds intimidating, but it really is very simple.
If understanding investing isn’t already complicated in the minds of many, the world of options seems to make it even more complicated and confusing. It doesn’t have to be so. An option is a contract. If you have purchased a car or signed a mortgage agreement, you have a contract. When our roof was damaged, the repairs were done after we signed a contract. Some contracts are verbal or just a handshake. So a contract is an agreement.
We all Execute Contacts That Are Promises
Without realizing it, many adults have contracts for many things in life that involve the dollar. It is likely that many of us will complete several contracts in the course of a month. When I place an online order with Amazon, using my VISA account, Amazon and I have an agreement. They can have my borrowed VISA money, and I will receive the product at the defined price by a defined date. I also then have an agreement with Chase, the issuer of my VISA card, that I will pay them back by the prescribed date either in part or in full. Chase has, because of the arrangement with Amazon, also promised me 5% in rewards for using the Amazon Chase VISA card.
A Stock Option is a Contract
If I enter an order to sell an option, or buy an option, I am creating a potential contract. I am entering into an agreement with someone that is binding. The agreement is legal and enforceable by my broker. If someone sells me an option, or I sell an option to someone, the order, when filled, creates, and defines the duties and obligations of the parties involved. There are four pieces to the contract.
What Are the Four Main Components of the Options Contract?
The four main parts are: 1) What am I selling? 2) What price do I want for my shares? 3) How long do I want the option contract to be in force – when will it expire? and 4) What price do I want from the buyer for the contract? This isn’t really much different from selling shares using a sell limit order. When I enter a sell limit order, I specify the stock or ETF I am selling, the price I want for my shares and how long I want the order to remain in the system. Here are the parts of the options contract in more detail:
1. WHAT AM I SELLING? First, I must agree on the “what” of the contract. The what is shares of something I own (or want to own). Most of the time we are talking about a single contract and each contract involves a minimum of 100 shares of stock or shares of an ETF. So, for example, the what for me might be some or all of the Broadcom (AVGO) shares I hold. Because I have 300 shares of AVGO, I can sell three identical contracts (in one order) for all three hundred shares, or I can sell three different 100-share contracts.
2. PRICE PER SHARE: The second element of the proposed contract is the price. If for example, my shares of AVGO are worth $555.91 as of the market close on Friday. I could decide to sell them at that price if the market was still open. What if I want more for my shares? I could also enter a “sell limit” order on Monday that offers 100 shares at $580.00 (or some price of my choosing) per share. If someone is willing to buy them for that price, then my order will execute, and I will receive $58,000 for my shares. Instead, I could sell a “covered call option” contract for the same 100 shares. In much the same way, I can specify the contract price for my shares. So I could enter an option contract for $550, $555, $560, $580, or any value well over $600 per share.
3. DURATION: How long will the options contract last? When you have a contract, you want to know when the contract ends. Options can last a week, or a couple of weeks, or a month, or several months. The normal expiration date for any option is aways a Friday.
It will be a Friday. Because AVGO trades option contracts weekly, I can choose to have my contract expire this coming Friday (December 23) or the following Friday (December 30.) I can also choose some Friday in January 2023 or February 2023 as well. I could even have a contract date of January 19, 2024. (That probably isn’t wise, but that is a topic for a future post.) The main thing is that options contracts always end on a Friday with a few exceptions for when the stock market is closed on a Friday.
I can also sell an option for an ETF like VYM. However, many stocks (CM, TD, PSTG, SQM, ASRT) and ETFs only have monthly options contract dates. For VYM, I can choose a contract date of January 20, April 21, and July 21. If you look at the calendar for 2023, you will see that these are always the third Friday of the month.
4. PROFIT: HOW MUCH DO I WANT FROM THE OPTIONS BUYER? Let me give an example. If I am selling someone the option to buy 100 of my AVGO shares, I have decided that I am willing to sell them for $580, a price above the current market price of the shares. To do this, I want to sell a “covered call option.” Don’t worry about the lingo yet, but it is “covered” because I own the shares, so I can sell them what I own. I can cover the contract with something I own.
If I know I only want the contract to last until December 30, I might be able to get a buyer to give me $2.50 per share for my 100 shares. In other words, if I enter a covered call order for 100 of my AVGO shares (one contract), and I specify the date as December 30th and my share price as $580, then someone might pay me $250 ($2.50 x 100 shares) for the potential to buy my shares on or before December 30th for $58,000. If on December 30th the shares are trading for something less than $580 per share, it is very likely that I will keep my shares and the $250 in profit from the options contract. At this point, don’t worry about why a buyer of my contract thinks this is a good idea. I will explain this in a future post.
A real example from a Contract I sold.
On Wednesday, December 14, I sold one contract for 100 of my AVGO shares. I set a contract price of $630 per share, which is about $74 per share more than the closing price on Friday. In other words, I want about 13% more for my shares than the current market price.
Furthermore, I set a contract date of December 23, which is this coming Friday. Therefore, the contract is only valid from December 14-23. There is roughly only a 9% chance that the shares will reach $630 by 12/23, so the price I could charge for the contract was fairly small: $0.50 per share. The buyer of my contract also realized that they probably wouldn’t get my shares, but it was worth $50 for the opportunity to grab them at a good price if the share price shoots up.
After a commission of $0.65 and a fee of $0.03, I received $49.32 for about five minutes of work. The income was the $50 for 100 shares less the $0.68 in total commissions and fees.
An option is a contract. The contract has only four parts. Those parts include the ticker symbol of the shares, a price I want for my shares, a contract end date, and the amount I want for the contract. All contracts expire on Fridays. There are some investments that have weekly options and others only have monthly options. The less risk you are willing to take, the less a buyer is willing to pay for your options contract.
Parts 3-4 of this Series Help Lay the Foundation
Now that we know the pieces of the options trade, I will talk about the types of options I trade in the third part of this series. We will then define how to decide what the four pieces of the contract will be in a fourth post. In other words, how do I select which shares I am willing to sell? What might cause me to skip trading options on an investment for a week or a couple of months? The goal is to get the income but keep the shares so that you can trade again-and-again. For example, I have completed 20 options trades for AVGO in 2022 to gain $10,206.68 in income. So on average, I made $510 per trade in profit. I also kept my 100 shares each time.
For the advanced student: This screen image illustrates one of the ways to look at AVGO options on Seeking Alpha. It shows the contract date I selected, a share price in the “Strike” column, and the Bid/Ask prices at different strike prices. We will discuss this in a future post as well.
Links for Learning – Today’s link is “What are Options?”
If you want to read more on your own, then here is a helpful article from Investopedia. There is a short video on the link that is a good summary of options in general.
Options Contract: What It Is, How It Works, Types of Contracts