Option Contracts Explained: Your Guide to Key Terms and Concepts
Option is a tool, like every tool there are risks, but utilized properly it can boost your portfolio and generate profit.
Options is a very powerful tool, understanding it can boost your investments by enabling you to purchase stocks at a discount, protect your current holdings against potential market movements, and can even help you generate consistent income if applied correctly.
The Risk of Option Trading
But before we dive in, I need to make it clear that there are risks involved. I literally saw someone lose $10,000 trading options, but on the other hand, I personally have made over $3000 in profit trading options in the past 4 months.
Let’s break it down, step by step, so you can start trading with confidence
The 4 Basic Types of Option Contracts
Let me first explain the basics of options trading. There are two main option contracts. Calls and Puts and you can either sell these or buy these two option contracts. So in total, you get 4 basic types of option contracts.
Selling Calls = the contract of Selling the obligation to sell 100 shares at a certain price (Strike Price).
Buying Calls = the contract of buying the right to Buy 100 shares at a certain price (Strike Price).
Selling Puts = The contract of selling the obligation to buy 100 shares at a certain price (Strike Price).
Buying Puts = The contract of buying the right to Sell 100 shares at a certain price (Strike Price).
Basic Concepts
Obligation = You are forced to exercise your option contract.
Right = You are not forced and have the freedom to exercise your option contract.
1 option contract = 100 shares
Strike price = The fixed price at which the option holder may buy (call) or sell (put) the underlying asset.
Expiration Date = the last date the option contract can be exercised. This is something that you decide, there are 0DTE ( 0 date to expire) contracts which expire the day of contract and there are LEAP’s options that expire a year later and there are many contracts length in between.
Capital Gains = the name of the profit, when you sell a share for more than you paid for.
E.g. Paid $100 for Google Stock, then sell it for $170. Capital Gain = $70
Premiums = This is the cost of each option contract. In any platform, the premium shown is for only one share. Since each option contract has 100 shares, you have to multiple the premium by 100 to get the actual price of the premium.
If you Sell a contract = You collect Premium
If you Buy a contract = You Pay the Premium
Stock Movements = So despite the stock price changing daily, in options contracts, you only have 3 ways that a stock price can move.
UP, the stock price increases in value and goes above the strike price.
SIDEWAYS, the stock price stays the same, the same as when you opened your option contract.
DOWN, the stock price decreases in value and goes below the strike price.
Option Chain = Where you see all the option contracts available for the stock you have selected.
(ITM) = (In The Money), a strike price below market price
(ATM) = (At The Money), a strike price that equals to market price
(OTM) = (Out of the Money), a strike price that is above the market price.
Curious how all the pieces fit together? See how mastering the 4 basic option contracts can position you for real profits—check out these two articles!
Put Options for Beginners: Simple Strategies to Profit in a Down Market
Call Options for Beginners: Easy Strategies to Start Investing Smarter
Or drop a comment for any other questions.