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A Guide to Understanding Options

A Guide to Understanding Options
February 20
20:05 2012

You’ve probably been told at some point in your life—quite possibly by one of your parents—that “there’s no such thing as a free lunch.” While we won’t debate the merits of that statement here, there is an investment that offers the next best thing: the option. Options give you the ability to capture the potential upside of a stock yet reduce your risk of loss. They also enable you to invest in more shares of that stock than you normally could, without the hazards associated with margin trading.

An option is merely a contract, and the term “option” is in fact short for “option contract.” That contract gives the holder the option to purchase or sell a specific security at a specified price on or prior to a set date. (We’ll talk about some specific terminology in a moment.) What’s particularly significant is that the contract holder merely has the option—not the obligation—to make that purchase or sale, yet the issuer is bound to sell or buy on demand. While it’s a seemingly one-sided deal, the combination of those two factors is what gives options much of their power.

Both the holder and the issuer of an option are essentially betting (though “betting” is such an ugly word to use when talking about investing) that the underlying stock will move in a certain direction—and they’re on opposite sides of the question. To make this discussion a bit easier to follow, let’s define some terms, and then we’ll consider an example.

First, the players: the person who buys an option contract is the holder; the person who sells that contract is the writer. As we already mentioned, the holder is not obligated to act on the contract, but the writer is. Since an option is not stock itself, but just a contract governing the buying and selling of a particular stock, that stock is referred to as underlying the option.

Second, there are two forms of options. A call gives the holder the option to buy a stock at a given price; a put gives the holder the option to sell a stock at a given price. Doing either is called exercising the option.

Finally, we mentioned that the contract specifies both a price and a time limit. The price the underlying stock must reach for the option to be eligible for exercise is called the exercise price, which is both more obvious and less sexy than the alternate term: strike price. (We’ll use the sexy term in this discussion.) The holder may not exercise a call until the stock price reaches or exceeds the strike price; he may not exercise a put until the price reaches or falls below it. Strike prices, by the way, are usually set in increments of $2.50 or $5.00.

As for time limits, the option contract also includes an expiration date, which we hope is a self-explanatory term. If the option is not exercised by the expiration date—either by the holder’s choice or because the stock fails to reach the strike price—it expires worthless.

Now, writers don’t offer option contracts because they are good-hearted people worthy of sainthood alongside Mother Theresa; they’re in the market to make money just like anyone else. A holder who buys an option pays a premium, and that money passes to the seller no matter what happens with the option itself. (We won’t get into the mechanics of how the premium is calculated here, as the process is complex and beyond the scope of this discussion, but suffice it to say that it involves the interaction of several factors including the strike price, the current price of the underlying stock, the time remaining until expiration, and how volatile the stock is—that is, how quickly and by how much its price varies.)

The bottom line is that holders of calls are betting (we can just as easily substitute the word “assuming”) that the underlying stock will risk in price, while the writer is betting that it will not (or at least will not rise to the strike price). That way the option expires worthless, and the writer pockets the premium and walks away. The opposite scenario is true for puts; the holder assumes that the stock will drop in price to or beyond the strike price.

Wall Street seems to like colorful terminology, which may account for the fact that a call option that has an underlying stock that has exceeded the strike price is called in-the-money. A put option is in-the-money when the underlying stock price drops below the strike price. Any other condition is called—neither very surprisingly nor very originally—being out-of-the-money. (If you find this confusing, just think about whether you’d rather be in-the-money or out-of-the-money.) Once an option is in-the-money, it has an intrinsic value, which is the difference between the current share price and the strike price, multiplied by the number of shares the option represents.

There are two basic kinds of options. The garden-variety option, which is what we’re discussing here, is the listed option, meaning that it is traded (or “listed”) on a national exchange. Listed options are highly standardized; they have set strike prices (the $2.50 and $5.00 increments we mentioned previously) and always expire on the third Friday of the month (or Thursday, should Friday happen to be a holiday). Listed options also always represent 100 shares of the underlying stock.

The second variety is the exotic option, which is usually a specially-negotiated contract. If you envision the options market as a medieval map, listed options are sitting squarely in the middle of Europe while exotic options are off in the white space that’s labeled “Here be dragons,” and we’re not going there.

All of this, we assure you, will be ever so much clearer with an example.

Let’s say that Acme, Inc. is trading at $57 on March 1. You’ve noticed that the coyote seems particularly determined to get the roadrunner this spring, and he’s been buying a lot of Acme products, so you’re convinced that the stock is headed up. Surveying the available options, you see that the May 60 Call (a call option expiring on the third Friday in May with a strike price of $60) carries a premium of $2.90 per share. That means a call will cost you $290, since listed options are always for 100 shares of underlying stock. (To keep the example simple, we’ll ignore commissions.)

In purchasing a call, you’re assuming that Acme stock will rise. Although the strike price is $60, you paid a premium of $2.90 per share, so your breakeven is at $62.90, not $60.

Moving forward to April 15, we find that Acme’s share price has climbed to $71. You’re in-the-money! You have three choices at this point: exercise the option, sell the option, or hold the option. (We’ll talk about selling the option next.) Thinking that Acme still has a little more steam, you decide to hold the option.

Tragically, on May 2 the coyote is killed in the tragic malfunction of one of his elaborate traps. Acme has just lost its best customer and a primary revenue source, and the stock price plummets. By mid-May the share price is hovering near $45, and on the third Friday, your option expires worthless. You’re out the $290 you paid for the call.

Let’s consider what you could have done back on April 15. You could have exercised your option, paying $6,000 (100 shares x $60 strike price) and then immediately selling them for the market price of $71, garnering a profit of $810 ($7,100 ‒ $6,000 ‒ $290). You might also hold the shares hoping for a further increase. Of course, doing either would mean putting up $6,000 in cash—and that’s just for a single option contract. For that reason, few option contracts are actually exercised. The Chicago Board Options Exchange (CBOE) says that the number is about 10%, while 60% are closed out and 30% expire worthless.

Closing out a position refers to the sale of an option contract by the holder. Don’t worry—doing so doesn’t make you the writer; the contract is now between the original writer and your buyer. To see how this works, let’s go back to our Acme example.

On April 15, with the share price at $71, the premium on the May 60 Call is now $7.50. It’s so much higher mainly for two reasons: the expiration is much closer, and the share price is well above the strike price. Taken together, these two factors mean the writer has a substantially greater risk of losing money, so the contract price reflects this. At that point, you could close your position, selling the call for $750 and netting $460 ($750 ‒ $290).

The other lesson you should take from this example is the leverage to be gained from options—the almost-free lunch we alluded to at the beginning of this discussion. First, your maximum loss in this transaction was $290—the premium on the call. Second, closing your position on April 15 would have netted you $460, and to have achieved the same profit through buying shares outright would have required an investment of $2,520 (42 shares x $60, sold at $71). Plus, had you held those same shares until late May, your loss would have been $630 (the $15 share price decrease x 42 shares)—over double the call premium. (All of this assumes that you deal strictly in options and never actually exercise a contract.)

As you can see, options provide both risk mitigation and leverage—a fairly rare combination in the financial world. Naturally, you should still analyze every trade with care. Just because the losses on option trades are relatively small doesn’t mean you should risk them unnecessarily. After all, death by a thousand cuts is still death.

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