- Why Options?
- The Basic Concept of Options
- Major Differences Between Stocks and Options
- A Detailed Explanation of Options
- Comments
This chapter is from the book
This chapter is from the book
This chapter is from the book
Major Differences Between Stocks and Options
Leverage
Options typically cost only a fraction of the stock price. If you think XYZ stock, currently at $49 per share, is going up in price, you can purchase 100 shares at a cost of $4,900. If instead you buy 1 call option contract (1 contract represents 100 shares of stock), you might pay only $2 per share for a total of only $200 to participate in an upward price movement of XYZ.
Analogously, if you think XYZ is going down in price, you could short 100 shares of stock, but that creates a margin responsibility in your brokerage account, which can become costly if XYZ goes up. If instead you buy one put contract, you might pay just $2 per share for a total of only $200 to participate in a downward price movement of XYZ.
Time Limitation
One reason options are cheap is that they are time limited. A long or short position involving stock can be held indefinitely, but an option expires on a fixed date. The expiration date is typically the third Friday of the expiration month designated in the option contract. When you buy an option, you can select from various expiration months, including the current month as well as other months going out possibly as far as two years.
The longer you want to hold an option, the more expensive it will be. If a price of $1 per share applies to an option expiring in two months, a similar option expiring in four months might be priced at $2 per share. For 12 months, the price could be as much as $7 per share, but even this would typically be a small fraction of the stock price.
Another important aspect of being time limited is that the value of an option will decrease with time when there is no change in the stock price. If you buy an option for $1 per share with two months until expiration, for example, it might be worth only $.65 with one month to go if the stock price has not gone up. This is one of the risks of owning an option, namely that its value diminishes over time when the stock price remains unchanged.
Price Movement
As the stock price changes, the option price also changes, but by a lesser amount. How closely the change in the option price matches the change in the stock price depends on the reference price designated in the option contract. This reference price is called the strike price.
When you decide to purchase an option, there will be several strike prices from which to make a selection. For most stocks, the strike prices of its options are set at $5 increments within the broad trading range of the stock. For some lower- and medium-priced stocks, strike prices are offered in increments of $2.50, whereas options on some high-priced stocks only have strike price increments of $10.
There is a terminology used by options traders to describe the relative relationship between the stock price and the strike price of an option. If the strike price of either a call or a put is close to the price of the stock, the option is said to be at-the-money. If the strike price of a call (put) is above (below) the stock price, the option is said to be out-of-the-money. If the strike price of a call (put) is below (above) the stock price, the option is said to be in-the-money.
For an at-the-money option, the price of the option will change by about 50 percent of the amount of change in the stock price. For an out-of-the money option, the price of the option will change by less than 50 percent of the change in the stock price. The price of an in-the-money option will move by more than 50 percent of the change in the stock price.
For example, suppose XYZ stock is priced at $49 and a call option with a $50 strike price is purchased for $2 per share. If the price of XYZ stock rises by $2 up to $51 soon after purchasing the option, the price of the call would typically increase by about $1, raising its price by up to $3 per share. Suppose instead, a call option with a $55 strike price was purchased for $.75 per share. Then the same $2 move in the stock price might increase the price of the call by only $.20, up to $.95 per share. On the other hand, a call option with a $45 strike price and a cost of $5 per share might see an increase in the price of the call by as much as $1.60, up to $6.60 per share.
Of course, if XYZ fell $2 from $49 down to $47, the call option with a $50 strike price could be expected to lose about $1 per share, reducing its price from $2 down to $1. This illustrates how the leverage of options works in both directions.
Financial Risk
When you buy an option, your maximum risk is limited to your original cost of that option. The worst outcome is that you hold the option until expiration, at which time it has become worthless because the stock price failed to move in a beneficial manner.
For example, if you buy one option contract for a price of $2 per share, your cost is $200 (2 x 100 = 200). This is the most that you can lose. Compare that dollar risk with the risk of either owning or shorting 100 shares of stock. When the stock price undergoes a substantial move against your long or short position in the stock, the dollar loss will be much greater than the cost of a call or put option.
A major risk with options is that you invest heavily by purchasing numerous contracts and then allow them to expire worthless. This represents a 100 percent loss on a significant investment. Of course, it is rarely necessary to lose all of your original investment when the stock does not move as expected. Typically, you can sell your options before expiration and recover some part of your original cost.