Options Basics: Stocks, Payoffs & Puts & Calls

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  • 0:00 What Are Option Contracts?
  • 1:20 Calls and Puts
  • 1:54 Payoffs
  • 5:14 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Many people believe the financial markets are limited to buying and selling shares of stock. But, in addition to stock, there are other financial instruments. In this lesson, we'll learn about option contracts - one such variation of stock shares.

What Are Option Contracts?

Besides the buying and selling of shares of stock in the financial markets, there are financial instruments known as derivatives. A derivative is a financial instrument that has its value based on the value of a separate financial instrument.

Imagine there are five envelopes, each holding somewhere between $10,000 and $50,000. Each of those envelopes has a cash value: the amount of cash it holds. You randomly pick a ball with a sticker on it that says either 1, 2, 3, 4, or 5. How much is your ball worth? Alone it's worth a few cents. But if you get the envelope with the number matching your ball, that ball is worth somewhere between $10,000 and $50,000. We don't know how much exactly yet, but we know it's worth something, because the ball gets its value from the cash in the matching envelope. The ball is a derivative of the cash in the envelopes.

Option contracts are derivatives that receive their value from the price of a share of stock. When you purchase an option contract on a share of stock, you are buying a contract that will give you the right to buy that stock at the strike price, the price agreed on in the contract, on or before the strike date, the date on which the contract expires, or the right to sell that stock for the strike price on or before the strike date.

Calls and Puts

The price of an option is quoted for a single share, but an option contract is for 100 shares of stock. So if an option is selling for $1.10, that contract will really cost $110 ($1.10 * 100). It was mentioned earlier that an option could allow you to buy or sell stocks at a predetermined price. You don't get to choose what you want to do after you buy the contract; you have to decide if you want the right to buy the stock; if so, you buy a call. If you want to be able to sell the stock, you would buy a put.

Payoffs

Before we can talk about the payoffs you can earn through options, let's make sure the information so far makes sense by using an example. A share of XYZ costs $50; not an option, but the actual shares of stock cost $50. We know that price will move based on economic events and company-specific events. For whatever reason or analysis, you believe XYZ is going to go up to $55 in the next two months. You have $3,000 to invest, so you could buy 60 shares of XYZ, and if it goes up to $55, you would make $300 (10%) in a couple months. Not bad!

But, what if you use options? Using your broker, you find call options with a strike date about two months away and a strike price of $52.50. They are quoted at $1.75 per share. That means each contract would cost you $175. For your $3,000, you could buy 17 contracts ($3,000 / $175).

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