What Are Options?

Have you been interested in options, but are unsure about how to take the first step to figuring them out? In this clip, Motley Fool Options expert JP Bennett gives a beginner's intro into what options are and how they work.

There are only a few basics to options, and once you've mastered them, a world of new investing opportunities will open up to you. Watch this clip to learn the difference between calls and puts, what they mean for options investors, how investors might layer them together in an options strategy, and more.

A full transcript follows the video.

This video was recorded on March 24, 2017.

Dylan Lewis: To kick us off, what are options?

JP Bennett: In a nutshell, options are what are referred to as derivative instruments. They derive their value based on something else. In this case, it's the underlying stock. Apple (AAPL 0.64%) options are going to have a value based on where the stock of Apple is trading at a given time. And although I think most listeners will know that there are a myriad of options strategies with crazy names and a bunch of different options positions, it might seem like there's so much to learn. But if you boil it down, there are really only two options you can use. There's calls and there's puts. Calls benefit when a stock rises. Puts benefit when a stock falls. And you can either buy or sell them. So, there's really only a couple of basics that you just have to master, and then the world opens up and you have a myriad of possibilities, in terms of strategies that you can do.

Lewis: Yeah. And you get into that complexity when you start layering these different options together. So, how do they work, and what are the different elements that people need to focus on? Because, at the end of the day, these are really contracts, right?

Bennett: Yes. They're derivative instruments, but they enable you to use leverage. Every options contract represents the right to control 100 shares of a given stock. One Apple call contract represents the right to buy 100 shares of Apple. So, they really have the potential to leverage your returns, or leverage your losses. So, when you're using strategies, you have to be mindful of that. So if you look at a hypothetical company, the stock is trading at $100, if you own a call with a strike price -- just to double back, a strike price is the price that is specific to the option that you either buy or sell, and that's the pivot point for where the value is derived. The stock is trading at $100, you buy a call contract with a strike price of $100, that means that you have the right to buy shares at the price of $100, regardless of where the stock is trading at expiration. The stock could double and be at $200 at expiration. You still get to buy shares for $100. So, that's where your profit comes from. If the stock is trading at $100 and you buy a call contract with the strike price of $90, then you get the right to buy those shares at $90. For every stock, there is specific expiration dates. Within that expiration date, there are a bunch of different strike prices. It will depend based on where the stock is trading, how liquid it is, and things like that. So, you can tailor the strategy to suit your needs.

Lewis: If you're looking at a call option, and that is, if you're going to go long, the opportunity to buy a stock at a predetermined price, what you're really looking at here is the exercise price, the duration, and then the premium that you're paying for that contract. That's the fee that you're paying for the optionality.

Bennett: If you want to get into the weeds in terms of how options are priced, there are really only a few matters that really determine the price. Like you said, the strike price in relation to the stock price. The implied volatility -- so, a stock that really doesn't do much, it just meanders along, the odds of it moving significantly from where it currently is is pretty low, so the premium that you just mentioned that you will have to pay for that isn't very high. You have to worry about the risk-free rate -- though, in current environments, you really don't have to, because it doesn't have much of an influence. And, you have to worry about how long the option will be alive for, so to speak, because they are instruments that have a finite life period. So, you can buy options for some stocks that expire at the end of the week. In some cases, you can buy ones that go out up to two years. So, there are just a few things that you really have to have a handle on to make sure. I don't really think we have time to get into the weeds in terms of pricing and determining whether or not you're getting a fair price. But, there are really only a few factors that you have to focus in on.

Lewis: We talked about calls, do you want to talk a little bit about puts as well?

Bennett: Yep. Puts. If you think about, specifically, put writing, that's actually one of our bread-and-butter strategies in Motley Fool Options. If you think about it, put writing, whereas calls benefit when the stock goes up, puts benefit when the stock goes down. So, if you're bearish on a stock, you could buy puts. But actually, what we prefer to do is sell puts. When you're selling a put, you're going to bring in that income. If you buy an option, you have to pay for that right to either sell shares at a given price or buy shares at a given price. When you sell an option, you're taking, essentially, the other side of that trade. So, you're being compensated for that. If you sell a call, you may have to sell shares at the strike price. Because we don't know where the stock is going to end up, you're going to get paid a premium for essentially taking on that risk. When you sell puts, you're basically saying, "Maybe the stock falls below the strike price. We don't really know, so I'm going to require you to pay me a premium in order for me to take on that risk from you." So, if you want to think about it, one of the best analogies is probably, you're an insurance company in this case, you don't really know what's going to happen, but you can help someone in terms of protecting them from a stock falling. In order to protect them, to provide that insurance, you have to be compensated. If you buy auto insurance, they don't just provide you that insurance for free, you have to pay them for them to be willing to take on that risk. So, basically, in the case of writing puts, you find stocks that you really like, you find a strike price that you're OK with buying shares at, and you make sure you're getting fairly compensated in terms of the premium that you'll collect. And you basically become the insurance company for the person who's taking the other side of that trade.

Lewis: And the logic with that is, you would be buying these shares at a price that's lower than the current market value. So, because it's a company you like anyway, you're willing to, say, buy it at $90 three months from now, even though it's trading at only $100.

Bennett: Yeah. Go back to Apple, it's around $140, it's like, "$135 is a great price for Apple. It's not there yet. I would buy it as soon as it hits that. But in the meantime, I'm going to collect some income by selling puts at that strike price. If it gets there, great, I'll get those shares. If not, at least I'll have generated some income while I'm waiting for that to happen."