What Are Options?
Understand the fundamentals of options contracts, how they differ from stocks, and why traders use them for income and hedging.
What Are Options?
An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a specific price before a certain date. Unlike stocks, where you own a piece of a company, options are derivatives - their value is derived from an underlying stock.
Options vs. Stocks
| Aspect | Stocks | Options |
|---|---|---|
| Ownership | Own part of a company | Own a contract (right to buy/sell) |
| Expiration | Never expire | Expire on a specific date |
| Price Movement | 1:1 with market | Leveraged, can move more or less |
| Income Potential | Dividends only | Premium from selling options |
| Risk | Can lose investment | Can lose premium or more |
Why Trade Options?
Traders use options for several key reasons:
1. Generate Income Selling options (like in the wheel strategy) creates premium income. This is like being paid to agree to buy or sell a stock at a specific price.
2. Leverage Options let you control 100 shares with less capital than buying the shares outright. A $50 stock costs $5,000 for 100 shares, but an option might cost just $150.
3. Hedging Options can protect your portfolio. Buying puts on stocks you own is like insurance against a drop in price.
4. Flexibility You can profit whether stocks go up, down, or sideways - depending on your strategy.
The Two Types of Options
Call Options
- Give you the right to buy 100 shares at the strike price
- Buyers want the stock to go UP
- Sellers want the stock to stay flat or go DOWN
Put Options
- Give you the right to sell 100 shares at the strike price
- Buyers want the stock to go DOWN
- Sellers want the stock to stay flat or go UP
Key Terms You Need to Know
| Term | Definition |
|---|---|
| Strike Price | The price at which you can buy/sell the stock |
| Premium | The price of the option contract |
| Expiration Date | When the option contract ends |
| Underlying | The stock the option is based on |
| Contract | Each option controls 100 shares |
Example: A Simple Call Option
Let's say Apple (AAPL) is trading at $175:
- You buy a $180 call option for $3
- This costs you $300 total (100 shares × $3)
- You have the right to buy 100 shares at $180 until expiration
If AAPL rises to $190:
- Your call is worth at least $10 ($190 - $180)
- Your $300 investment is now worth $1,000+
- Profit: $700+
If AAPL stays below $180:
- Your call expires worthless
- You lose your $300 premium
The Wheel Strategy Approach
In the wheel strategy, we focus on selling options rather than buying them:
- Selling puts = Getting paid to potentially buy a stock at a lower price
- Selling calls = Getting paid to potentially sell a stock at a higher price
This shifts the odds in our favor because most options expire worthless - and when you're the seller, that means you keep the premium.
In the next lesson, we'll dive deeper into how options work mechanically.