Stock Options Explained

Maybe you have read that an option is a right to buy something 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. Any investor can get 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 make any moves. 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–I’ll explain puts and calls, 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.  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, options do not afford you this luxury.

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.

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 you to have stock options explained to you. I hope I did a good job presenting stock options basics – the concepts, the potential rewards, and certainly the risks. 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 position, is a stock option explanation for another day and if there’s enough interest I might cover writing options in another tutorial.

Many investors have never even heard of stock options selling. For most people options trading is synonymous with risk and potential big profits or losses, using leverage. However, a lot of savvy investors use strategies involving selling options, also known as options writing, to hedge existing positions against the possibility that the stocks that they already own, or are short, will move against them.

Now hedging with options is nowhere near as exciting as leveraging with options and doubling or tripling your money quickly. Perhaps this is the reason you don’t get the details of options selling explained as frequently in books or on websites on stock options basics. It certainly is a lot more exciting than losing all the money that you have put into a long option position though, which happens all too often, unfortunately!

By writing puts and calls you can benefit from the fact that the great majority of long put and call positions, i.e. where put/call contracts are bought, are losing bets for the buyers. When an investor engages in writing options, he attempts to make money in a way that is exactly the opposite of buying options. In a nutshell, the options seller takes the other side of the buyer’s much riskier position. In this way he has a corresponding likelihood of profiting. The risk, as well as the potential for gain, is smaller. However, many good investors will take consistent gains over a mix of big wins and frequent losses of an entire position.

Example time. I will talk here about writing calls against stock that you own. The mechanics are the same if you write puts against stock that you are short, only the directional movements are reversed for writing puts.

It is April and you own 100 shares of ABC, which is trading at the moment at $33 per share. You feel good because you were right about the stock, having bought at $25. You don’t think it’s done moving up though, and you have no intention of selling at $33. At the same time you recognize that a pullback or some consolidation might be in order, and you would appreciate a way to reap some of the benefit from this position without actually selling your shares. You can sell one ABC August 35 call, at $1.50, let’s say. You are selling someone the right to buy 100 shares of ABC at 35 by the end of the third week in August, and for this you are paid $150 in this case ($1.50 X the 100 shares that the contract represents).

The person on the other side of the transaction, the call buyer, has paid a relatively small amount of money for an out-of-the-money option that may very well expire worthless, in the hope that the stock will continue its upward rise and give him a very high percentage gain. In addition to the possibility that the option will become in-the-money and have intrinsic value, he also would benefit by having the stock move as soon as possible so that he may sell before time decay hurts the value of his option too much.

As the option seller you accept an amount that is small relative to the size of your position ($3300 at the moment), but it functions as a small insurance policy protecting you in case the stock does have a pullback from $33, temporary or otherwise. The $150 premium you receive lowers the cost basis of the position for you. You bought at $25, but now this position has cost you $23.5, or $2350.

If the stock is below $35 per share on expiration day, roughly 4 months from now in August, you keep your ABC stock as well as the premium amount. Over the four months that premium represents approximately a 13% annualized return (150*(12/4)/3300=~13%).

What if the stock price is above the strike price on expiration day? Well, you must deliver 100 shares of ABC at $35 per share. Having bought the stock at 25, you are still pretty happy, but the critical thing to recognize is that if the stock keeps going past $35 a share you would have missed out on any move above $35 directly because of the insurance that you purchased to guard against a drop back in the price of the shares. Still, another thing in your favor is also the premium amount that you get to keep.

Note the clean inverse relationship between the motivations of the options buyer and option seller, and the ways in which each stands to benefit.

The option seller wants to hedge and is happy with a small return relative to the size of his existing position. Time decay is his friend; all else being equal, the price of closing his position before expiration goes down each day, until expiration when the option expires worthless (if it’s out of the money) and he keeps 100% of the premium and his shares, or (if the option is in the money) is forced to sell his shares at a gain while still keeping the premium he received.

The options buyer uses leverage for a possible large percentage return. The passage of time will work against the value of his position (notwithstanding volatility and other factors beyond the scope of this article).

That is the basics of stock options selling explained. If you do your homework you might find that writing covered options gives you a fairly good shot at making relatively small but consistent gains over time.

Why do I say “covered” options? What are covered calls and puts and why the qualification?

A covered call writer owns 100 shares of the underlying security against which the call is written, for each call that he has written. (A covered put seller is short 100 shares of the underlying security for each put he writes) You could establish a covered options position by selling a call or put contract against a stock position (long or short, respectively) that you already have established, as in our example, or you could buy or short shares at the same time as you write an option against them.

Writing uncovered or naked options means that you do not own the underlying shares, if you are writing calls, or you are not short the underlying shares if you are writing puts. At expiration you would be required to

So what’s the big deal about naked puts and calls? In a word, risk. There is a huge difference between selling “covered” options versus selling “uncovered” or “naked” options, in terms of risk between the two.

As a call option contract gives you the right to buy 100 shares (or for puts, to sell 100 shares) of the underlying security at a given price on a given date in the future, there must be a place from which these shares are delivered (or a counterparty who will buy the shares, for puts) if the option is in-the-money on expiration day.

As the options writer or seller, you have been paid an amount of money, a premium, to assume that responsibility. If the option is exercised and you do not already have the shares in your account as a call seller (or if you are not already short the shares as a put seller), delivery of 100 shares for every call contract that you have written (or purchase of 100 shares for each put you wrote) would be a relatively large, immediate expense to you.

But the real problem here, for a naked call position that goes against you, is that you would be forced to purchase shares at the current market price and sell them immediately at the strike price, which would be below (and maybe far below!) the current price of the stock in the case of an in-the-money call. For a naked put position whose strike price is higher than the stock price by expiration day, you would have to buy 100 shares for each contract that you have written, at a higher price at which you can currently buy the stock.

For calls, you would immediately lose the difference between the strike price and the price at which you may currently buy the shares in order to fulfill your obligation to deliver. For a naked put position that goes against you, you must buy the stock that the put buyer owns the right to sell (a terrible sentence I know; I hope it makes sense).

This is one case where writing naked puts and naked calls have different outcomes if the trade goes against you: when your naked put position concludes at a loss it is only a paper loss. Buying the shares at the strike, higher than the current market price, leaves you with those shares. With naked calls, immediate delivery equals an immediate loss.

Either way, if you have many contracts this could add up to a lot of money, especially when compared to the relatively small amount that you received for writing the options. Brokerage firms will require that you have money enough in your account to cover (literally) naked options positions that go against you, in lieu of owning the shares. There is a possibility that even a option contract that was far out-of-the money when you wrote it could expire in-the-money. You must show a way to address this possibility, whether through cash in your account, equity, or by simply owning (or having short) shares of the underlying stock equal to the shares represented by the contract(s) that you have written (i.e. covered puts or calls).

To circle back a little, hopefully you can see clearly now why writing covered puts, against shares that we are short, keeps us safe from a downturn: if we are forced to buy shares at the strike price at expiration, we are simply covering an existing short position at a profit. It’s the inverse outcome of a covered call position where the stock price rockets higher. We have lost only the opportunity cost of missing the big move, in return for the insurance of the call, or put, that we would have been better off not writing. Having naked options positions go against us leaves us facing a very different type of music, though maybe slightly less dire in the case of naked puts, as we can theoretically hold our newly purchased stock until it comes back…

So to recap, an options seller normally trades away the prospect of benefiting if his underlying long or short position runs far in his favor, i.e. beyond the strike price of the option he writes. In return he receives the premium from the options buyer, which can be though of as insurance against a the stock moving against him (as it reduces his cost basis), and a simple windfall if the stock trades sideways. Keeping the proceeds from these premium amounts if positions work out in your favor can give you very respectable gains, though really never triple-digit home runs as can happen with long option positions. Sometimes sophisticated investors establish naked options positions, but they are quite speculative and require sophistication and financial wherewithal.

In the real world, writing options is especially well-suited to investors with large portfolios who would like to protect paper gains that they might have, or reduce their cost basis when they open up a position. The benefits of selling options must always be weighed against the fact that they reduce the potential profit of a given long or short stock position. Sometimes letting a stock continue to move in your favor with a trailing stop is a good way to have a nice gain turn into a huge gain, even without leverage. Capping a position’s potential gains by selling an option against it is probably not a strategy you should use for every single stock that you buy or short. There are many strategies one may use with covered options; another good one is writing naked puts to buy a stock lower than its current price, or simply pocket the premium if it never gets there before expiration.

Even though writing options (at least covered options) is safer than buying options, it’s not for everyone. Having stock options explained to to you properly, as I hope I’ve done, does not reduce the risk of trading them. Please consult a financial professional before investing in them.

A put options explanation can be given in a couple of sentences, as in: a put option is an options contract that gives the buyer of the put the right to sell 100 shares (per contract) of the underlying security at a given price, by a specified date in the future. The put seller, on the other hand, assumes the obligation to buy 100 shares of the underlying stock at a given strike price, by a defined expiration date in the future.

You may have a pretty good understanding of stock options basics in both buying and selling call options, which in their simplest forms usually involve assuming risk through leverage when buying calls, and alternately, offer opportunity to reduce risk by hedging, when selling calls (also known as writing calls).

For some people though, buying and selling put options is a little harder to understand. After all, how can the put buyer sell 100 shares of something he does not own? How in turn can a put seller fulfill his obligation to buy 100 shares of stock that the put buyer does not own?

This confusion is easily cleared up when you recognize that this transaction is consummated simply by both parties fulfilling their obligations. In an effort to get put options explained for you once and for all (!), I will cover what happens both when the stock price is below the strike price and above the strike, at expiration.

If Stock Price Is Above Strike Price At Expiration

On the options expiration date, if the price of the underlying security is above the strike price, i.e. out of the money, then the put option will not be exercised because the right to sell shares (the put buyer owns this right) at a price that is lower than current market price would be worthless. The put would expire worthless and this would benefit the put seller, or writer, as he keeps the premium that he was paid upon entering the position. If the put seller had entered the position to hedge shares that he was short, keeping the options premium in this way will reduce his cost basis for the shares that he is short. The put buyer in this case would lose the entire purchase price of the put.

If Stock Price Is Below Strike Price At Expiration

On the other hand, if the price of the underlying stock at expiration is below the put contract’s strike price, i.e. in the money, the put option buyer will exercise his right to sell 100 shares at the strike price. If he was long shares of the stock, he has been protected by his put purchase from any decline in the stock price below the strike price. This is one way that buying puts function as insurance if you are long the underlying stock: for the premium that you paid you are protected until expiry from a fall below the strike. (Another way that puts can function as insurance is if we see a sudden appreciation in the put contract price because of a decline in the stock price, and we sell. In this case the profit from selling our put would reduce our cost basis of being long the stock, as it declines) If the put buyer was not long shares, exercising his option will leave him short 100 shares (per contract he owns) at a higher price than where the stock is currently trading: a good outcome. If this is hard to understand, just think of it this way: it is exactly the same as a call buyer exercising his call when the price of the stock is higher than the strike. His position will no longer be leveraged, but he owns the shares with a paper profit of the difference between the strike and the (higher) stock price, times 100.

In this scenario, the put seller is forced to buy 100 shares of the underling stock at the strike. This means he has an immediate paper loss of the difference between the current stock price and the strike price, times 100 shares, unless he was hedging a short stock position (in which case he simple covers his short at the strike). If he is not short the shares, buying 100 shares for each of the multiple contracts that he might have written would represent a very large out-of-pocket expense.

When would you sell puts? When would you buy puts?

If you are short the underlying stock but fear that there might be a short-term increase in the price, you could sell one put contract for each 100 shares that you are short, as a hedge. If the stock price at expiry is above the strike, you keep the put premium and your cost basis for your short shares is reduced, as previously stated. Of course, the downside is that if the stock continues to go down and its price is below the strike price at expiration, as the put seller you will miss out (relative to the shares that you are short) on any downside move beyond the strike price of the put, as you are obligated to buy (in other words, cover your short in this case) 100 shares at the strike price for each contact you have written. There are other times when you might sell puts too, for instance if you decide that you like a stock but feel that it is currently too expensive. You could pick a price at which you’d like to own it, and write a put with that strike price for each 100 shares you are prepared to purchase. If it does not reach the strike you keep the premium you received, and if it does reach the strike you could buy it at that price. There is no guarantee that it won’t go still lower, of course!

You would buy puts if you are interested in taking advantage of a price decline that you’re expecting in a stock, using leverage, ie with less money than your broker would require you have in your account to go short. The potential downside of this leverage is that you could lose the entire amount that your put contract(s) cost you. The upside is that if you are correct, a given decline in the stock price will probably result in a much higher percentage gain on the money you have invested than if you had simply gone short. Stock options basics must absolutely be intertwined with an understanding of leverage.

If you feel you have not had put options explained adequately to you, or anything about stock options explained well enough for that matter, let me know in the comments, please.

I have decided that discussing stock options basics for beginning investors with no previous experience at stock options trading might be worthwhile. I’ve received a few comments that indicate that readers would appreciate some basic, clearer definitions of options terminology, along with another explanation of the basics that is less wordy than the ‘stock options explained‘ article that leads off this site. I’ll do my best.

Stock Options Basics: Seeing Both Sides of the Trade

Financial exchanges created options as investment products which give people more choice as to where to put their money. Rather than simply buy or short stocks, options give you the chance to diversify by using investment funds in two primary ways. Read the rest of this entry »

Many visitors to this site are interested in getting the basics of stock options explained clearly to them, perhaps for the first time. While options are too risky for many new investors, for those readers who have decided that using leverage with a small portion of their investment funds is appropriate for them, it seems fitting for me to cover trading tools like stock option software. As difficult as options trading is, you can find lots of help in automating the process of sifting through potential opportunities.

There’s a wide range of stock option trading software available, and while you certainly can spend a lot of money on a sophisticated software package there is also excellent options software that are available for free download. Be aware that sometimes companies will offer what sound like stock option systems that in fact involve pricey advisory services, subscription-based memberships or managed option strategies. This is not to say that these programs do not have value of course, but in your search for free stock option software be aware that you will be bombarded with more expensive offers as well.

I’ve written these stock options software reviews for reference to help you in your trading, and I expect Read the rest of this entry »

Don’t let the word ‘continuum’ make you click away; my point is that most investing neophytes think of stock options as risky investments and it’s just not the whole story. While it’s true that going long with calls or puts means that you are risking most or all of your investment funds in that particular position, it might be helpful to explain option trading in terms of a risk continuum, because the fact is that there are conservative option strategies as well as risky ones that traders can employ.

The idea of using just a little bit of money to control 100 shares of stock per contract that one buys, thereby benefiting from potential moves in the stock that one anticipates, is attractive for some traders or investors (and lots of speculators!). Certainly leverage has a place in some portfolios, to be taken on with only a small percentage of one’s investment capital. The stories one hears of traders doubling or tripling their money in a week or less certainly are accurate, though as you might expect the likelihood of this happening is quite low for most people, certainly much less than 50%. Having said that, one can still use a strategy of buying puts and calls when one has a hunch that a move might occur in the short-term. While long-term options, called LEAPS, can be employed successfully if you have a longer time horizon, buying options is usually done with an eye toward a short-term gain because of the time decay that premiums suffer as a contract gets closer to its expiration date.

So let’s look at the other side of this continuum. Many people with larger portfolios use writing, or selling, puts and calls as a way of augmenting their portfolio such that they actually reduce their overall risk exposure. If you think of options only as risky investment vehicles then that might surprise you-here’s how these conservative option trading strategies work: Read the rest of this entry »

The last month or so the stock market has had a run-up of about 10% in terms of the S&P 500; the path wasn’t straight up, but still the rise has been quite impressive. If you are mostly long in your stock portfolio you are feeling some relief compared to the low point just before July 4th, 2010. This might be a good time to explain how a protective put strategy works, as something to consider if you are afraid that stocks may be headed down, at least temporarily, from here.

On this site you have had stock options explained to you in terms of using leverage to aggressively profit from a rise or fall in underlying stock, as well as having call and put options explained as ways to hedge existing positions, with safety as the goal.

You can use puts to protect gains that you may have in your portfolio, or more specifically profit from possible downside moves in stocks or ETF that you might own but do not wish to sell at this time. Reading the financial commentary right now, you’re hearing an awful lot about the possibility of a double dip recession, which would naturally be detrimental to your long stock positions. Buying, or going long, put options is a way to purchase some insurance for your portfolio, and though this ‘protective put’ strategy carries with it some risk, it can be put to good use just like buying insurance, because even if the events you fear do not occur, buying protective puts enable you to sleep better knowing that you have covered yourself, just in case. And, if the underlying stock should fall, the gains you see in the value of your puts will at least partially offset the paper losses you experience in your stock position.

The mechanics using this protective insurance are really quite simple: Read the rest of this entry »