- 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
A Detailed Explanation of Options
Additional insight into options from both the owner and seller viewpoints is provided in the more detailed explanation that follows here.
The Option Contract
An (equity) option represents a contract between a buyer and a seller. This contract is an agreement concerning the buying or selling of a stock at a reference price during a stipulated time frame. You will never see any written document for this contract, just as you do not see actual shares of stock that you purchase in your brokerage account. The existence of the option contract is implied as soon as you buy or sell an option through your broker.
We will continually refer to the buying and selling of options. In case you are wondering where all this buying and selling takes place, there are exchanges for trading options similar to the exchanges for trading stocks. Your broker routes your order to buy or sell an option to one of those option exchanges, just like he sends your order to buy or sell stock to a stock exchange.
There are rights and obligations associated with an option contract, which need to be understood. Options associated with individual stocks trade in a manner called "American style," which permits the owner of the option to exercise the rights of the contract at any time before the option expires. To better comprehend the implications of an option being exercised, we examine the call option and the put option from the viewpoints of both the buyer (owner) and the seller (writer).
The Call Option
The buyer (owner) of a call option has the right to purchase 100 shares of stock at the strike price designated in the contract. This right to purchase can be exercised anytime before the contract expires. Typically, the time frame of the option extends through the third Friday of the expiration month stipulated in the contract.
The seller (writer) of a call option has the obligation to supply 100 shares of stock for purchase at the strike price, if so requested by the owner of the option. This obligation to supply the stock may be required at any time before the contract expires. As a practical matter, if the stock price is below the strike price, the stock is almost never "called" away from the seller. Even when the stock price goes above the strike price, the assignment of a call rarely happens until near the expiration date.
Buying a Call Option
The motivation to buy a call option could be based on your expectation that the price of XYZ stock will soon rise above its current level. Let's set up a possible trade, clarify its risk, and examine some possible outcomes resulting from the trade:
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Trade. In early February, with XYZ trading at $49, you decide to buy one call contract to benefit from the expected rise in the stock price. To allow a reasonable amount of time for XYZ to advance, you select a contract with an April expiration. You also select a strike price of $50. Option prices are quoted on a per-share basis, and let's suppose that this call option costs $2 per share. Because the option covers 100 shares of stock, this means you pay $200 to own this particular call contract.
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Risk. Your risk on this trade is limited to the $200 paid for one call contract.
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Outcome. Let's examine a few scenarios to see how this trade might work out:
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Suppose your faith in XYZ stock is validated as its price reaches $54 by the end of March. Now your right to purchase XYZ at $50 looks good, and you decide it is time to take your profit. Should you call your broker and tell him to exercise your right to purchase this stock at $50? No, because you will do much better if you just sell the option. The option you bought for $2 is likely to now be worth $5.50. So, the contract for which you paid $200 can now be sold for $550, giving you a nice $350 profit. That represents a 175 percent profit on the option, whereas the stock price has risen only 15 percent.
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In contrast to the happy Scenario 1, let's see what happens in the unfortunate case when XYZ is under $50 when the April options expiration date arrives. If you remained stubbornly optimistic until the end, you would have seen the value of your option diminish until it expired worthless. In this worst-case situation, you would lose all of the $200 that you originally paid for the option. Usually, there is no need to incur such a complete loss. If XYZ is still around $49 in early April with only a couple of weeks left until expiration, you might conclude that the chance for success looks remote. Then sell your option for whatever value remains. Suppose that you could sell the option for $1 per share and thereby close the trade for a 50 percent loss. The decision to limit your loss on a long option trade to 50 percent is a reasonable exit strategy.
In the jargon of options, you are "long one XYZ Apr 50 call." Now you have the right to purchase 100 shares of XYZ stock at $50 per share anytime before the close of trading on the third Friday of April. This right to purchase XYZ stock for $50 per share does not look so good at the moment, because the stock is priced in the market at only $49. Indeed, why have you paid $2 per share for something that presently has no intrinsic value? Because the expression "time is money" is most appropriate as it applies to options. You paid $2 per share as a cheap way to participate in the movement of the price of XYZ stock until the call expires in two months.
Why is this option worth $5.50 when its intrinsic value is only $4 (54 – 50 = 4)? Again, because "time is money," and the person who buys your call option is paying the extra $1.50 per share over its intrinsic value in hopes that XYZ stock will go even higher before the April expiration.
Let's see why selling the option is more profitable than exercising it. If you had exercised your option to buy XYZ stock at $50 and then immediately sold the stock at $54, that would be a $400 gain on the stock, less the $200 cost of the option for a net profit of only $200. So, exercising the option yields only a 100 percent profit as compared with the 175 percent profit received from selling the option. Also, selling the option avoids any issue about having enough cash in your brokerage account to take ownership of the stock.
Selling a Call Option
Suppose that you own 100 shares of ZYX stock, which at the current price of $67 is above where you bought it, but now seems to be stalled. It would be nice to make a bit more money on this stock, and you would be quite happy to part with it at $70 per share. This could be your motivation to sell a call. Selling a call would immediately bring some cash into your brokerage account, and if ultimately you are required to give up your stock for $70 per share, that is an additional gain. Let's set up a possible trade, clarify its risk, and examine some possible outcomes resulting from the trade:
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Trade. In early February, you decide to sell one call contract on ZYX. You pick the $70 strike price and a March expiration. The March option is selected so as to have an early resolution as to whether your stock will be retained or sold. Suppose that you are able to sell the March call for $2 per share. Because the contract covers 100 shares of stock, that brings in $200, which is yours to keep.
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Risk. Your risk here is the usual risk of owning a stock, because its price could drop significantly. To a small degree, this risk is offset by the decrease in value of the short call.
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Outcome. Let's examine a few scenarios to see how this trade might work out:
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At expiration, ZYX is at $71. Your stock is called away for $70. You have made $2 per share for the call that you sold, and the stock is being sold for $3 more than the $67 it was worth when you sold the option. Thus, you have a $500 gain since the time that you initiated the option trade.
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If ZYX is slightly above $70 as expiration nears, you might decide that you do not want to part with your stock. Then you must buy back the short call. If ZYX is hovering around $71 on the expiration day, you can probably buy back the call option for a bit more than $1 a share (even at expiration it will cost you a little more than its intrinsic value). This gives you a profit of the difference between the $2 that you took in from the sale of the call less your approximate cost of $1 from buying it back. Now you get to keep your stock, but if its price soon begins to fall, you may regret the decision to keep it.
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If ZYX is only $69 at expiration, the call that you sold expires worthless. You already have the $2 from selling the option, and you also retain your stock. The cost basis for your stock has been lowered by $2 per share. Now you can repeat the process in the next month. If you were able to continue bringing in $200 every month with this covered call strategy, that represents a 36 percent annual return on a $67 stock that does not even need to go up in price. If the stock goes up gradually and each month you can sell a call at a higher strike price, things are even better.
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Suppose that ZYX has pulled back to $64 at expiration. Now your stock has lost $3 per share from the time that you sold the call. This unpleasant situation is somewhat relieved by the $2 per share received for the call that you sold. In this case, your net loss is only $1 per share.
In the jargon of options, you are "short one ZYX Mar 70 call." Also, this particular combination of owning a stock and selling a call is referred to as a covered call position. Chapter 14, "Covered Calls," discusses this type of trade more fully.
You now have the obligation to give up your stock at $70 a share if someone exercises that right against you before the close of trading on the third Friday of March. Does this mean your stock will be called away as soon as its price is a penny over $70? No, because under most circumstances you only need worry about losing your stock within a few days of the expiration date. Why? As illustrated previously, until near the expiration date, the owner of the option will always profit more by selling it than by exercising it. Of course, as the expiration date is reached with ZYX above $70, someone is ultimately going to exercise their option and call away your stock.
Things look a little different if ZYX is $74 at expiration. Your stock will still be taken away at $70, and you have exactly the same $500 gain that you had when ZYX closed at $71. But in this case, you could have made $700 on the stock if you had not sold the option. Of course, that $700 gain is unrealized unless you actually sell the stock at $74. One benefit of the covered call trade is that it forces some discipline upon you to take a profit and get rid of a stock that possibly has little upside left in it.
The Put Option
The buyer (owner) of a put option has the right to sell 100 shares of stock at the strike price designated in the contract. This right to sell can be exercised anytime before the contract expires. Typically, the time frame of the option extends through the third Friday of the expiration month stipulated in the contract.
The seller (writer) of a put option has the obligation to buy 100 shares of stock at the strike price, if so requested by the owner of the option. This obligation to purchase the stock may be required at any time before the contract expires. As a practical matter, the stock is never "put" to seller if the stock price is above the strike price. Even if the stock price is below the strike price, the put assignment typically does not happen until near the expiration date.
Buying a Put Option
The motivation to buy a put option could be based on your expectation that the price of XYZ stock will soon fall from its current level. Let's set up a possible trade, clarify its risk, and examine some possible outcomes resulting from the trade:
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Trade. In early February, with XYZ trading at $39, you decide to buy one put contract to benefit from the expected fall in the stock price. Because you expect XYZ to decline following an earnings report in early March, you choose a March option. You also decide on a strike price of $40. Let's say this put option costs $3 per share. Because the option covers 100 shares of stock, this means that you pay $300 to become the owner of this particular put contract. You are now "long one XYZ Mar 40 put." This gives you the right to sell 100 shares of XYZ stock at $40 per share anytime before the close of trading on the third Friday of March. This right to sell at $40 per share is a slight improvement over its current price of $39; however, that gain of $1 per share is offset by the $3 per share paid for the option. Why have you paid $3 for something that has an intrinsic value of only $1? Again, "time is money," and you have paid an extra $2 per share of time value in order to play XYZ for a downward move until the put expires in March.
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Risk. Your risk on this trade is limited to the $300 paid for one put contract.
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Outcome. Let's examine a few scenarios to see how this trade might work out:
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The earnings report for XYZ is indeed weak and the stock sinks to $34. Now your right to sell XYZ at $40 per share looks good. Does it matter that you do not own any XYZ stock to sell? No, because if you are ready to take your profit, all you need do is sell the option. The option you bought for $3 is likely to now be worth $7. So, the contract for which you paid $300 can now be sold for $700, giving you a nice $400 profit. That represents a 133 percent profit on the option, whereas the stock dropped only about 13 percent.
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In contrast to the happy Scenario 1, let's see what happens in the case when the price of XYZ stock is still at $39 when the March options expiration date arrives. The earnings report failed to negatively impact the stock price and you have stubbornly refused to accept that outcome until the end. Then you would have seen the value of your option shrink from $3 down to its intrinsic value of $1. You could then sell the option for $100, which represents a $200 loss based on the $300 paid for the option.
Why is the option worth $7 when its intrinsic value is only $6 (40 – 34 = 6)? As said before, time is money, and the person who buys your put option for $7 is paying an extra $1 per share over its intrinsic value in hopes that XYZ will go even lower before the March expiration.
Let's see why selling the option is better than exercising it. To assign the option, you would first need to buy the stock at $34 per share and then exercise your right to have someone buy the stock at $40 per share. Your gain would be $600 on the stock less the $300 you paid for the option, giving a net profit of only $300. So, exercising the option yields a 100 percent profit as compared with the 133 percent profit received from selling the option.
Selling a Put Option
Suppose that you shorted 100 shares of ZYX stock when it was $65 a share. It has fallen to $62 in early February, but seems to be stalled at that price level. You do have a $300 profit, but your original goal was to ride this stock down to $60 for a profit of $500. This could be the motivation for selling a put option. Selling a put would immediately bring some cash into your brokerage account, and if ultimately you are required to close your short position at $60 per share, that is an additional gain. Let's set up a possible trade, clarify its risk, and examine some possible outcomes resulting from the trade:
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Trade. In February, you decide to sell a March contract so as to have an early resolution on the position of being short ZYX stock. You find that you can sell the March $60 put for $2 per share, which brings $200 into your brokerage account. You are now "short one Mar 60 put." This means that you might be required to buy 100 shares of ZYX at $60 per share at anytime before the March options expiration date. For all practical purposes, this is not going to happen unless ZYX is below $60 as the expiration date nears. If you are required to buy the stock at $60, your broker will immediately use those shares to close your short position in ZYX, which you initiated at $65.
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Risk. Your risk here is the usual risk of being short a stock, because its price could rise significantly. To a small degree, this risk is offset by the decrease in value of the short put.
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Outcome. Let's examine some scenarios to see how this trade might work out:
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Suppose that ZYX is still at $62 when the March expiration date arrives. Because the stock price is above the strike price at expiration, the option expires worthless. Now you can keep the $200 that you received from selling the put option and your short position in the stock remains in place. Thus, you have managed to make some additional profit on this short position, even though the stock is right where it was when you sold the put.
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If the price of ZYX is at $59 at expiration in March, you would be required to buy 100 shares of the stock at $60 per share. These purchased shares would immediately close your short position in ZYX. Now you have achieved your original goal of riding the stock down from $65 to $60, plus you have brought in an extra $2 per share from selling the put. This yields $500 from the short sale of the stock plus $200 from the option for a total profit of $700.