Learning Options for the SIE Exam, Series 7 Exam, or the CFA® Exam can be daunting. Consider it like learning a new language. There is plenty of jargon to know: call, put, in-the-money, out-of-the-money, premium, strike price, etc. To simplify learning Options however, while tutoring I accidentally stumbled upon a simple technique. Although you might still choose to memorize some of the basics (think: call up, put down), this might help add to your understanding.
Let’s dive in.
Learning Options with The Lottery Ticket Technique
Imagine for a moment that you can buy two types of lottery tickets. A green ticket and a red ticket. With either ticket, you can win a lottery that will pay out a reward. When you buy your lottery ticket from the lottery ticket sales person, you both agree that if the ticket is a winner, whatever you win, the seller will pay out. In other words, the seller loses whatever the buyer wins.
If the lottery ticket proves to be a loser, then the buyer’s lottery ticket becomes worthless. In such a case, the buyer of the lottery ticket is out the price of the lottery ticket, while the seller does not have to pay out any winnings. This case is of course ideal for the seller. He/she just collects the income from selling the buyer the ticket.
Connecting the Dots
For anyone paying attention, you might notice the similarities to such a lottery game and how options work. Let’s connect the dots now, and carry the analogy over to options. The two lottery tickets above can be referred to as “calls” and “puts”. Each has their own rules for winning.
In order for the buyer of the call “lottery ticket” to win, the market price of the stock must exceed the strike price before expiration. Your prize would be the difference between the market price and the strike price. You will have to subtract the price you paid for your lottery ticket to calculate your total profit.
For example: Sally purchases 1 ABC March 30 call at $2. If Sally is able to exercise the option when the market price is $36, then she “won” $6 ($36-$30) from the lottery ticket. Since the ticket cost her $2 to buy, she pockets $4 total.
When it comes to the other lottery ticket – the put option – the market price must fall below the strike price in order for that ticket to win. In that case the winner’s haul will be the difference between the strike price and the market price of the stock.
For example: Now Sally purchases a second lottery ticket. She buys 1 DEF April 25 put at $1.50. If Sally is able to exercise the option when the market price is $21, then she “wins” $4 from the lottery ticket ($25-$21). Since the ticket cost her $1.50 to buy, she pockets $2.50 total ($4 – $1.50).
Now for the Reverse
In the above examples, Sally was the buyer of the lottery tickets in both cases. Naturally, the next question becomes: What about the seller?
When Sally purchased the call option lottery ticket she shelled out $2. If she purchased the ticket from Joan, then Joan collected the $2 but promised to pay Sally out the winnings if Sally won the lottery. Unfortunately for Joan however, Sally did in fact win the lottery. Hence, Joan received $2 initially for selling Sally the lottery ticket, but eventually paid out $6 to Sally for her lottery winnings. This results in a net loss of $4 ($6 loss – $2 income).
In the second example, Joan sold Sally a put option lottery ticket for $1.50. Unfortunately for Joan, the lottery ticket sales person, this was another winning ticket for which she was responsible to pay the proceeds to Sally. Joan received the $1.50 for selling the ticket, but was required (obligated) to pay Sally the $4 ($25 – $21) for her winnings. In all, Joan lost $2.50 ($4 loss – $1.50 income).
Hopefully the above helps illustrate a little deeper, the basic dynamics of options. It can get a lot more complex, so this should be a very basic starting point.
When it comes to Options, as a SIE Exam tutor I see a lot of memorization. Sometimes it can take a lot of time to truly understand options. Although memorization will be helpful, a deeper understanding will have a more lasting impact. Try to simplify your understanding of Options with a simple example like the above and you’ll find it might stick a little better.
Good luck!