Stock Options Explained

by Tom Mullaly on July 29, 2013

Maybe you have read that an option is a right to buy a stock at a certain price at a certain point in the future. Maybe such a clinical definition didn’t get you any closer to understanding what stock options are all about. I believe any investor can grasp the concepts if they have stock options explained briefly and clearly to them. But please remember: understanding this game and winning at it are two very different things. Consult a licensed financial planner or broker before you invest with real money.

Buying stock options can lead to the loss of your entire investment. Also, stock options given to employees as part of a compensation package are a subject for another tutorial, as are binary options–I’ll explain puts and calls in this article, buying stock options for one’s own portfolio. (I might cover writing or selling puts and calls in a future tutorial if there is enough interest)

To keep it simple I will cover only call options in this explanation, not puts-see this post to get put options explained. Calls give you the right to buy shares, while put options give you the right to sell shares, but just as I wouldn’t have to tell you how to do forearm curls with your left arm if I explained how to do them with your right arm, you will understand options mechanics–puts and calls–by simply understanding call option basics.

It is January 1 and the price of XYZ stock is $12 a share.

An options table tells me that an XYZ April 10 call option contract is trading at $3. Confused yet? Please stick with me! If I owned this contract I would have the right to buy 100 shares of XYZ at a price (the premium) of $10, until the call expires on the third Friday of the expiration month, April in this case. One option contact gives me the right to buy 100 shares of the underlying stock.

Since the stock is at 12 it is easy to see why this right would have value: if I exercised my right and bought 100 shares at $10, I could immediately sell the shares for $1200, for a net profit of $200. The definable, guaranteed, intrinsic value, the difference between the $10 strike price and the current stock price, is concept #1. (In practice, options contracts are not exercised before their expiration, they are simply bought and sold until they are exercised by the final contract holder at expiration)

In our example, why is the option contract priced at three dollars? The intrinsic value of the contract is two dollars–the difference between the price at which I have the right to buy the shares at where the shares are priced right now. But there’s another critical part of the contract’s value.

It’s January 1, so there is more than 3 1/2 months left in the life of the contract, until the third Friday in April. The price of XYZ, the underlying stock, will fluctuate in that time; the potential for appreciation in the underlying stock means that the option contract has time value, ($1 in our example), in addition to the intrinsic value ($2 in our example). Intrinsic value is a matter of simple math, but the time value is determined by the market. When I refer to time value and intrinsic value remember that they are simply components of the premium price. An option contract has only one price but it is instructive to examine the two components of that price.

Let’s tweak our example above to make this a little clearer. What if XYZ’s stock price dropped from $12 to $9 per share the day after we bought our option? The option was $2 ‘in the money‘ at 12; now it’s $1 ‘out of the money‘. With the stock at $9, the option to buy the stock at $10 has zero intrinsic value: you can buy the stock at a lower price than owning the option currently allows you to do.

But does this mean that the option has zero value? It is now January 2 and your April 10 call still has more than 3 1/2 months until expiration. A lot can happen in that time. Naturally the market will ascribe a value to the April 10s that is more than zero, and in this case the value will be 100% time value.

For a given amount of time left before expiration, the closer the stock price is to an out-of-the-money option’s strike price, the greater the time value. Also obviously perhaps, for a given price, the more time left until the contract expires the greater the time value. I want to only cover stock options basics now, and so I won’t address myriad subtleties that affect the time value of options contracts, except to say that everything else being equal, the higher the underlying stock’s volatility (propensity to change over time) the greater the time value, as determined by the marketplace, will be.

The important thing to remember about time value is that (everything else being equal) it is “decaying” all the time, as time passes and the days until expiration decrease. Time decay is one of the things that makes options trading tricky. While you could theoretically hold a stock position indefinitely waiting for things to move in your favor, stock option picks do not afford you this luxury. Getting options trading explained to you means grasping the implications of time decay.

Leverage: More Bang For The Buck

Maybe you’re wondering why a person would buy stock options instead of just buying the stock. Great question.

Let’s say you’ve been watching XYZ, and you have reason to think it is a good buy at $12 a share. For $1200 you could buy 100 shares. For the same $1200 you could buy four of the XYZ April 10 calls, presently trading at $3 (4 X $300– each contract covers 100 shares of stock).

Let’s say the stock goes to $15. If you bought 100 shares your position is worth $1500, and you made 25% on your original $1200 investment, whether it takes three days or three years to move to $15 per share.

What if, with the stock at $12, you had bought four XYZ April 10 options instead? If XYZ stock goes to $15 per share, the difference between the $10 strike price and the current stock price is $5. We know that owning these contracts gives us the right to buy the stock at $10, and that with XYZ at $15 we can sell them for five dollars ($500) each, plus whatever time value is contained in the option, as determined by the marketplace. Our $1200 position is now worth $2000, plus time value. Even if it is the Friday afternoon of the third week in April and there is zero time value left, our profit is 67%. This is an illustration of leverage, which allows you to control an asset using less money than it would take to buy the asset outright and therefore enjoy the benefits of an upward move in the price of an asset for less money. In this way, if your position is a profitable one, your percentage gain will be higher. The downside of leverage is that you can also be hurt more by a given move in the price of an asset, in terms of a percentage of what you invested. Central to any explanation of stock options basics is the double-edged sword of leverage. Per our example, let’s say that the price of XYZ after we purchased it at $12 per share simply drifts down to $11 per share. This gives each of our options and intrinsic value of one dollar ($100), so our four XYZ April 10 options are worth a total of $400, plus time value. As we get closer to the end of the third week in April, the time value slowly decays to zero. If XYZ is at $11 per share at expiration our contracts are still in the money, but we have lost 67% of our original $1200 investment. And what if the price of XYZ goes to nine dollars per share, and we hold on watching the time value decay to zero? At expiration there is neither intrinsic value because the contracts are out of the money, nor is there time value left. Our four options contracts expire worthless, and if we are human will probably wonder at least once or twice why we did not sell earlier, or why we didn’t buy the stock. Options explained easy doesn’t mean trading miracles guaranteed! A final scenario regarding trading options vs purchasing stock: What if XYZ moved very little after we bought it, but we held on to our four options contracts while the stock drifted up a bit from $12, to maybe $12.50 by expiration in April? What is the value of our position? As the stock is 2.5 points over the strike price, the math is 4 x 2.50 or $250 = $1000. This position cost us $200, even though we were right about XYZ! We just weren’t right enough. Owning the stock would have us at a $50 profit, and we wouldn’t be obligated to exit.

With options, even simply buying puts and calls, you can see how the challenge is more complex than simply being right about the direction that a stock will move. It gets more complicated from here, but many strategies allow you to reduce risk by not focusing on simple leverage to profit, i.e. by selling options. Hedging with options is covered here.

Question time:

What is so special about $10 a share, April, and the 3rd Friday of each month for that matter? Nothing. Strike prices, options expiration months, and the 3rd Friday are all arbitrarily set by the options exchange. Regarding strike prices, if XYZ is at $12 per share you might see contracts with strike prices in increments of one dollar between five and 20, and $2.5 or $5 increments higher than that. As the stock goes higher or lower, new contracts are created to trade as needed.

Am I obligated to hold my option contract(s) until the expiration date? Absolutely not. You may sell at any time. Holding contracts until expiration is rarely the motive for buying options. In fact, because the time value of an option is usually decaying, you must constantly reassess whether you think the stock will move in your favor, and move fast enough, to outweigh the time decay that will occur in the contract over time (the ways in which volatility or lack of volatility can bloat or reduce time value of premiums is beyond the scope of this tutorial). Most people “trade” options for the short term and sell their contracts well before expiration, simply trying to capture the move they hoped would occur, to avoid the additional time decay in the premium. With options, you want not only to be right, you want to be right as soon as possible! ‘Buy and hold’ is usually not a strategy that works with options (though there are option trading strategies involving long term options, called LEAPS, that we can cover in another article). Also, you should know that there are myriad free and subscription stock option software packages useful to help you determine just how long to hold your contact.

Having said that, you are entitled to hold your position until expiration day, at which time you are obligated to exercise your right to buy 100 shares of the underlying stock at the strike price. “Exercising your option” at expiry, which the final holder of an in-the-money option contract is required to do, will require additional funds to buy the shares of course, and you will have to pay commissions when you do sell later. The savings that you realize by buying shares at the strike price, which would be lower than the current stock price, can be had by selling your contracts immediately before expiration for just their intrinsic value (as all time value will be gone).

It may have only taken 10 minutes for me to give an overview of options for you. There’s admittedly more to it than explaining how to learn the stock market. Still, I hope I did a good job presenting stock options basics – the concepts, the potential rewards, and certainly the risks. If you are intent on having options trading explained to you that’s admirable, but I cannot emphasize strongly enough how hard it is to consistently make money by going long stock options. I’ve certainly heard estimates of more than 90% of put and call trades losing money. Writing or selling covered options, which is the other side of the more risky long call or put option position, is a stock option explanation for another day and if there’s enough interest I might cover writing options (ie selling options) in another tutorial.


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