To The Moon

We shall continue with where we left previously:

https://ttm.financial/m/post/9019884715?invite=S2ODHF&lang=en_US

After we went through on the basics of options, we will go through the types of options.

Options are split into call and put options.

Each of them represents a different direction.

U can visualise the direction by the action of calling someone.

When u call someone, u will pick up the phone. U can use the picking up action to remind u that call goes up.

When u end the call with someone, u will put down the phone. U can use the putting down action to remind u that puts goes down.

2 of the most common mistakes for new option traders is mixing up calls and puts, and mixing up buy and sell.

Try to use the imagery so that it will be easier for u to remember.

Let’s start with calls first.

When people talk about calls, they will usually associate with buying of call options or known as long call options.

Calls moves similarly as owning a stock just that the movement is a function of the stock. This relationship is also known as delta.

It’s like the wool of the sheep, the wool will not replace the sheep as the sheep.

The higher the delta, the more the wool will mirror the sheep. The highest the delta can go to is near to 1, but unable to replace the sheep at 1.

What this means is that, u can use a call option in place of a stock.

U can buy the wool, instead of the whole sheep. It will be cheaper for u to do that and yet get similar movement.

We will touch on delta later on. It is extremely important.

When u buy a call contract, basically u want to mirror the stock movement.

What happens if u sell a call contract?

Let’s use the sheep as the stock and the wool as the option premium.

The person (option buyer) who buys the sheep basically decided on the price that he wants to buy the sheep from u.

Remember that since it’s an option contract, both the buyer and seller agree to exchange the sheep at fixed price (strike price). In order to reserve the sheep at the fixed price, the buyer agree to provide a deposit for the seller by paying for the wool first (call premium).

The intention of the buyer is to fix a price ceiling for himself.

If the price of sheep went above the agreed price (In the money), the buyer will buy the sheep from u as it is cheaper to buy from u.

Let’s assume the strike price of sheep is $100. For the above case, as long as price of sheep is higher than $100 or even at $100 (At the money), the buyer would buy from u, as the price is same or he have savings.

In the event that the strike price is lower than $100, the buyer will ignore the contract, forfeit the payment for the wool and buy from someone else. This condition is called OTM (Out of the money)

Back to the seller, remember that the buyer wants to buy the sheep from the seller?

As it will be a physical exchange, when the sheep strike price hits $100 or higher, the buyer of the sheep, will bring the agreement to exchange for the sheep at $100.

In other words, when u sell call options and it expires ATM or ITM, the stocks will be transferred to the buyer of call option from the seller of call options.

Do also note the risk for buying and selling call options.

When buying call options, the “risk” is the deposit that u pay for the wool.

Option buyers have the choice of buying over of the stock at a lower price from the seller, if the stock goes to the moon. Option buyers will profit the difference from the moon to agreed price. (At or above strike price) This is known as assignment.

Option buyers can also choose to sell their contract to other option buyers who will takeover the contract on their behalf.

As such, call option buyers have limited risk and unlimited profit in theory, as there is no limit to how high a stock can go.

The reward for call option seller is the premium collected (deposit for the wool).

However the risk for call option seller, is either losing the stock which is pledged (sheep) otherwise known as covered call, or will have unlimited risk as the price of the stock could go to the moon in theory.

I hope that the above is clear enough with regards to call options, let’s move on to put options.

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When people usually talk about Put options, they refer to the buying of put options.

Try to remember it this way, see if it helps.

The P in the put option, stands for Protection.

Put options are used as protection in case of stock downside. It is the equivalent movement of shorting a stock.

But there are differences.

Apple to apple, shorting of stocks involves higher risk reward than buying put options.

When u short stocks, u do not own the stock. U have to borrow the stock to short, due to this, u will have to use margin and pay the interest on the margin.

In addition, if the direction goes against u, the required margin will increase and will get more costly.

In terms of risk, short sellers have unlimited risks due to the potential upside of the stocks. Say GameStop, ask those who gotten short squeeze how do they feel.

When u buy put contracts in lieu of shorting, u will get similar movement as shorting. However, ur loss is controlled to the amount of premiums u paid for the put options. That’s ur max loss, the risk is defined.

However, do note that as options contracts have time duration, the passing of time, will erode ur position. We call this process time decay.

Let’s go on to how does put options work.

U can treat put options as buying an insurance, hence the protection term.

How it works is as below:

When u buy a put option, u form a contract to determine what’s the max risk that u can accept. A price floor is formed in this case.

Let’s go back to the farmer.

Farmer is selling corn on top of owning sheep.

Due to recent rains, he is worried that the value of corn will drop as the rain affected the corn quality.

Corn farmer or corny farmer (put option buyer), went to find farmer (put option seller) who owns pigs.

Piggy Farmer promised corny Farmer, that he do not need to worry, as his pigs will eat all corn regardless of quality.

The 2 farmers decided on a price of $20 for the corn as exchange price (strike price). As a gesture of good will, corny farmer passed piggy farmer some money to form an agreement (put premiums), so that piggy farmer is bound by the agreement.

After the harvest, corny farmer realised that the corn quality isn’t as bad as he though, he can still sell at higher than $20. He quietly go sell his corn at higher price, whereas piggy farmer with the agreement money in his pocket, totally forgot about the agreement.

If after the harvest, corny farmer found out that the corn quality is worse than expected and he can only get lesser than $20. He will bring the agreement to piggy farmer and ask piggy farmer to buy over the corn from him at $20.

What this will mean is that, at the time of agreement expiration, if the put option expires ATM or ITM, the put option seller will buy over the shares (corn) from the option buyer.

For put options buyers, the risk is the put premiums paid, while max profit will be when stock reaches zero.

For put option sellers, the reward will be put premiums received, risk will be to buy over the stock at whichever price it is in.

The worst case will be $0 stock.

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I hope that the above description is clear enough to show the difference between calls and puts, and the basic usage of calls and puts.

Do note that there are 2 types of options styles. The above description is for European style options.

European style options can only be exercised by the option buyer at the time of expiration.

American style options can be exercised any time by option buyer as long as the price is ATM or ITM, which means strike price or better for the option buyer.

American style options usually have higher premiums than European style options due to this function.

Option Sellers are paid more for American style options as there is more risk due to potential early assignment.

Although there is risk in terms of early assignment, there are ways to avoid early assignment.

Call option seller be especially careful of ex-dividend days. Call Option buyers could do early exercise, so that they can collect the dividends, as they need the shares to collect the dividends.

With this, we will conclude for call and put options here.

Hope that the above information is useful to u.