Rule #1 Finance Blog

With Investor Phil Town

How Do Stock Options Work? A Guide to Options Trading

Did you know that Warren Buffett trades stock options?

You don’t have to be an options trader to be a Rule #1 investor, but the right kinds of options trades fit in beautifully with Rule #1 strategies and can increase your portfolio’s returns.

Options trading, done right, can even reduce the risk of owning stocks.

It’s worth saying, before we dive in, that you should always apply Rule #1 principles in investing, even with options – because if you wouldn’t want to own a company for 10 years, you shouldn’t own it for 10 minutes. 

This blog is meant only for education and entertainment purposes- nothing I discuss is my advice or recommendation. 

With that out of the way, let’s get started.

What Are Stock Options?

Stock Options Definition: Stock options are contracts that give the buyer (the “option holder”) the right to buy or sell (depending on the type of option) shares of a specified company at a specified price within a specified time period (on or before the “expiration date”).

The options themselves can also be bought and sold.

Now there is a lot to unpack there, so let’s talk a little bit more about how stock options work.

How Do Stock Options Work?

Stock options consist of “contracts,” which are made up of an underlying block of stocks – typically 100 shares.

When you trade stock options, you are essentially betting that the price of the stock will rise or fall (depending on the type of option) by the termination date.

Stock Option Basics

To give you some context, let’s pretend you are selling a stock option.

The person who is buying the stock options from you pays you a fee, called a “premium.”

Depending on the type of stock option, the premium the buyer pays gives them the right to either buy or sell the stock. We’ll discuss this further in a minute, but for now, just understand that it is either the option to buy or sell, but not both.

If the buyer decides to buy or sell the stock by the expiration date, the buyer is said to be “exercising” the option.

As the seller of the option, you get to keep the premium, whether or not the buyer exercised the option.

Stock Option Example

A version of options was originally created so that farmers who had wheat in the ground wouldn’t be at risk for huge price drops that would cause them to lose money by the time the wheat was ready to harvest.

So, they would find someone who would want the other side of the trade. 

Since the farmer is a wheat seller,  they’d want to find a wheat buyer – like a baker or similar.

The baker might want to lock in the price for wheat in June even though he can’t get it until September – and now both sides are guaranteed a fair trade when the wheat is ready.

Stock options are intended to work exactly the same way only instead of selling the right to a bundle of wheat, we are selling a group of stocks.

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The Difference Between Buying Stocks and Options Trading

You buy and sell stock options on exchanges, similar to the exchanges where you buy and sell stocks.

But, there are some significant differences between investing in stock options versus investing in stocks of wonderful businesses.

One important difference between stocks and options is that stocks give you a small piece of ownership in a company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.

Another main difference is that options trades are not held for the long-term – AND you know as Rule #1 investors that when we buy stocks we are planning on holding on to them for a long time.

Options are not a risky thing by default. It depends on the overall market and how you’re using them.

Now that you understand the basic principles of options tradings, let’s cover the two types of stock options and how they work.

Types of Options Trades

There are two types of pptions – “call options” or “put options

The basic difference between the two is that with call options, the buyer of the option gets the right to buy the underlying shares, and with put options, the buyer gets the right to sell them.

What is a Call Option?

Call options are a fantastic way to generate cash flow and reduce the cost basis on companies we already own.

We say that a call option is a “Rule #1 Call option” when we already own the underlying stock. Let me briefly explain how call options work.

Call Option Definition: A call option is a contract that gives the buyer the right to buy stock or another asset (the “underlying asset”) from the seller at a specified price (called the “strike price”) within a specified time (until the “expiration date”).

How Do Call Options Work?

The easiest way to start understanding call options is to look at an analogy. You could think of a call option as being like a coupon someone would take to the grocery store to buy a quart of milk at a set low price.

In this example, instead of clipping the coupon from an advertising circular, the buyer would pay the grocery store a very low price for the coupon.

There are two parties to this transaction, the coupon buyer and the grocery store.

The buyer of the coupon gets the right to buy a quart of milk at the set price. If the buyer decides to use the coupon, then the grocery store has an obligation to sell the milk to the buyer at the set price.

Whether or not the buyer ends up purchasing the milk, the grocery store gets to keep the price the buyer paid for the coupon.

Call options work in a similar way.

If you buy a call option, you get the right to buy the underlying stock from the option seller at the set price during a set amount of time.

If you are the seller of the call option, you become obligated to sell your stock to the buyer at the set price if the buyer requests it within the set time.

Selling Call Options

Why would we want to sell call options as Rule #1 investors?

If you own a company, and you sell someone the right to buy your stock at a price higher than you think the stock is worth, then there is almost no risk at all. If the stock price goes up to that unexpectedly high price, you would want to sell the stock anyway. You should always aim to sell into greed and to buy into fear.

When greed is pushing the stock price up like a rocket, you want to be a seller of that stock. You can increase your cash flow by selling call options, which give the buyer the right to buy your stock at a set higher price.

The buyer pays you a premium for the option, and you can put that money in your pocket.

If the stock price goes up beyond the set price, then you will sell the stock to the buyer. If the stock price doesn’t go up, then you get to keep the money that the buyer paid you as a premium. Either way, you win.

We love selling call options as Rule #1 investors when we already own the stock.

There is virtually no risk, and we get more money for selling stock that we would have sold anyway.

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How Call Options Work When You are the Seller

Let’s say you own 100 shares of Company ABC. Its current stock price is $108 per share.

Based on your assessment of the intrinsic value of the business and current market conditions, you believe that the stock price is unlikely to go above $115/share in the next month.

You look at the options quotes and select a call option for 115 with a premium of 37 cents with an expiration date of next month.

You sell one contract, and the buyer pays you a premium of $37 (0.37 x 100). Whether the stock price goes up or down, you still come out ahead.

If the stock price goes over $115/share, the buyer will exercise the option, and you will be required to sell your 100 shares at $115/share, which is $7/share more than they were worth when you sold the option.

If instead, the stock price never rises above $115/share before the expiration date, you will keep your shares and you also get to keep the premium.

How Call Options Work When You are the Buyer

Let’s say you buy 10 call option contracts with a strike price of $170/share and a premium of $16.

The total premium you would pay is the premium price x the number of contracts x 100, which in this case comes out to $16,000.

If the stock does not go over the strike price of $170 by the expiration date, then you would get nothing and would lose your entire premium.

However, if the price per share goes above the sum of the strike price and the premium price ($170 + $16 = 186) on or before the termination date, they you could exercise your option and buy the underlying stock for $170 and be able to buy it for less than its current market value.

What Is a Put Option?

A put option is like the reverse of a call option.

Put Option Definition: In a put option contract, the buyer gets the right to sell the underlying stock to the option seller at the specified price within the specified time, usually in a month or so.

In a naked put, you don’t need to short the underlying shares.

When you sell a put option, then you are willing to buy the stock at a price that is lower than what it’s selling for right now.

While you are waiting for the price to come down, you pick up a bit of income, and when the price does come down, you are happy to buy it from the option holder at the lower price.

How Do Put Options Work?

A put option becomes more valuable as the price of the underlying stock decreases.

Selling naked puts is a very good strategy when you are totally solid on the value of the business.

The problem with selling a naked put in the current market is that you might have to buy the stock at a price that is quite a bit higher than the price the stock is selling for — and that hurts.

Let’s take an example: ABC stock is selling today for $30 a share. You like it a lot at $20, so you sell someone the option to sell you the stock at $20.

They pay you $0.50 for that option. Then the stock starts dropping like a brick down to $15. Then the option holder requires that you buy the stock at $20. You must, and thus you immediately are 30% in the red.

And that’s why I’m not a huge fan of naked puts.

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The Risk Of Naked Put Options

For me, it’s mostly psychological. I love to be in cash and watch a price crash on a business I want to buy.

It’s like I’m a consumer of hamburgers, and the price of the burgers is going down, down, down. I LOVE it! My beloved burgers are getting cheaper by the day, and since I am a consumer of burgers, that’s a good thing for me.

But if I’ve set a limit to how cheap they can go by selling a naked put, then I only want the burgers to go down to that price and no further. That’s pretty hard to do — to nail the bottom price of something.

Especially since we know that Mr. Market is quite irrational sometimes, particularly when he’s panicked and afraid, and is fully capable of naming a ridiculously low price for a great business.

It is just horrible to have to pay more when Mr. Market is being so cooperative as to sell it to us at a massive discount below its true value.

And, fortunately, or unfortunately, that often happens: If we sell the option at a price that represents a nice margin of safety, we can’t be sure that Mr. Market won’t totally panic and sell far below the margin of safety price.

I’ve seen Mr. Market do exactly that over and over.

Naked Put Option Example

For example, in 2001, Valero, a wonderful oil field business, was worth about $20, and it was selling for $7. Urban Outfitters was worth $6, and it was selling for $2.

And there are more extreme examples that come up from time to time when markets do what they do — fluctuate.

If you had sold the put option for Valero at the margin of safety price of $10 or Urban Outfitters at the margin of safety price of $3, you had to start your position down about 30%.

That’s why it is important to really know what you are doing before trading options and to have a solid understanding of the intrinsic value of the business.

How to Trade Options

The basics of stock options trading are to first, choose the stock that you wish to use as your underlying asset. Then you will need to do your research and decide if you think the stock price will rise or fall.

And then look at the available option quotes, which will give you a choice of combinations for strike prices, termination dates, and premiums.

As I’m mentioned before, stock options trading is not a risky thing by default – but they can be risky if you do not understand what you are doing. 

It truly depends on the overall market and how you’re using them.

There are some options strategies that are especially terrific for Rule #1 investors, such as the collar, where you buy a put and sell a call – a strategy that limits your risk if the stock price falls, while still letting you benefit if the stock price rises.

Learn more about our options strategies and all our Rule #1 investing strategies in our  3-day transformational workshops.

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.