Introduction to Stock Options
Stock options can be risky and expensive, so why trade them? Because they are versatile securities that can fulfill many objectives including improving portfolio growth, protecting assets, limiting risk, leveraging assets, and speculation. Options can help make a profit whether the market is moving up, down, or barely moving at all.
It is common to think of options as risky investments. While they certainly can be risky, they can also be used to hedge against loss, thereby reducing risk.
The objective of this tutorial is to provide a basic understanding of stock options, explain how they are typically used, show how market factors effect option pricing, and explain how option activity can signal stock price movement.
An overview of popular strategies such as covered calls and protective puts are explained, as are more complex strategies such as spreads and straddles.
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What is an Option?
First the basics: there are two basic types of options, CALLS and PUTS.
A CALL is the right, but not the obligation, to buy a security at a specified price for a predetermined period of time.
A PUT is the right, but not the obligation, to sell a security at a specified price for a predetermined period of time.
Calls and puts are contracts between a buyer and a seller. The buyer of the option has the right, but not the obligation to take delivery of an underlying asset. The option buyer is also called the holder.
The seller of the option has the obligation to deliver the underlying asset. The seller has written the contract to deliver the underlying asset and is referred to as the writer.
Options can be American style or European style, chooser options, employee stock options, options on stocks, indexes, futures, or have a myriad of other twists. We’ll keep this discussion simple by limiting it to CALL options on stocks.
Let’s start with an example, Apple Computers stock (AAPL) is trading at $51 and you feel strongly AAPL will rise in price. You could buy 1000 shares for $51,000. If your predictions are right you will profit, but if you’re wrong, you stand to lose $1,000 for each point the stock drops. Although your gains are potentially unlimited, you can potentially lose the entire $51,000.
What if you could reap the benefits of AAPL moving up without incurring the risk of loss if the stock goes down? If you purchase the right to buy the stock at a specified price, say $50, you would still profit if the stock price rises. If the stock rises to $60 before the option expires, your option would be worth at least $10, (your option gives you the right to buy the stock at $50 and you could immediately sell the stock for $60). If the stock goes down in price you would not be obligated to buy the stock, therefore you would not suffer the loss, your option simply expires worthless. Sounds great, but there’s one catch – the option is not free. The amount paid for an option is called the premium. The premium paid for the option is the most the option buyer can lose, therefore the risk is limited. The probability that some or all of the premium will be lost is relatively high, so the risk factor is high.
The seller of the option has taken on a much larger risk. If the stock rises in price the option seller is obligated to deliver the stock at $50. If the stock goes to $60 the option holder will exercise the rights, and the option seller must sell the $60 stock for $50, losing $10 a share. There is no limit to the option seller’s risk.
Which trader, the writer or the holder, has a better chance of profiting from the trade? The answer is neither, the option should be priced such that the option seller receives enough premium to offset the risk of the stock rising above the current price. This calculation involves a number of factors which are discussed later in Chapter 3.
Definition of Option Terms
Objectives of trading options, options pricing, disparities in pricing, and complex option strategies will covered in the chapters that follow. There are a lot of terms and concepts introduced, and we need to define a few before moving further.
In the above example, AAPL is the underlying stock. The option holder has the right to buy AAPL at the strike price of $50. The underlying stock price is $51. The underlying price ($51) is more than the strike price ($50) by $1, therefore, the option must be worth at least $1. The option is in the money by $1. The amount the option is in the money ($1) is the intrinsic value. The rights of the option holder expire on the expiration date. The length of time between the purchase of the option and the expiration of the option is the term.
An option is a contract to buy or sell a fixed number of shares, usually 100, of the underlying stock. The premium is the price of an option and is quoted on a per-share basis. An option contract quoted at $1.75 will cost $175, plus commissions. The minimum option purchase is 1 contract. Contracts listed by the exchange typically cover 100 shares of the underlying stock, but that is subject to change as a result of stock splits, mergers, spin-offs, large dividends, or other corporate actions.
The objectives of trading options are discussed in Chapter 2.