The site traffic analysis software that I use for stockoptionsexplained.com tells me that there is a huge range of specific questions that people have regarding getting options trading explained to them that I never could have anticipated, as revealed by searches that people perform that lead them to this site. While I hope that the content here is informative enough to explain stock options basics to anyone who’s trying to understand them, I thought there might be value in providing answers to specific questions.
I’ve paraphrased some of these questions; we all tend to type short phrases when we search. Still I’m pretty sure what questions were behind each of these queries.
Do I have to hold my options contracts until the call date?
It’s a good question; if you buy April 100s, can you sell the option before the Friday of the 3rd week in April when the contract expires? After all, the underlying stock might make the move that you anticipate or the bottom might drop out, leaving you deciding to exit your position.
The answer is that selling options is possible at any time before the expiration date. In fact, one undercurrent that you will come to realize as you get options trading explained to you is that only a small percentage of options buyers intend to hold until expiration when they initiate the trade. Some options traders might only hold their puts or calls for a matter of minutes. Leveraged as they are, options can have huge swings in their prices over the course of even one day, and if you are nimble and fortunate enough, making large percentage gains in one day is certainly possible. Be warned though: this is exceedingly difficult to do, and very, very few people can do it with the consistently you’d need to do to justify attempting it. A large percentage of straight put and call buys are losing trades, often 100% losses.
Does buying options require purchasing the stock?
Absolutely not. The whole point of buying a put or call is to benefit from a move in the underlying security without having to put up the funds that would be required to buy or short 100 shares outright. You simply pay the premium amount to buy the contract with the particular strike price and expiration date that you want.
However, if you are writing (aka selling) puts or calls, you will normally own 100 shares of the underlying stock for every call you write, or be short 100 shares of the underlying for every put that you write. This means that you have the shares on hand to deliver should the call option expire in the money. In the case of put writing, you will be short 100 shares of the underlying and prepared to cover (i.e. buy shares) at the strike price. Owning or being short the underlying stock like this means that hedging with options is what you’re interested in, as a way to protect your stock or short position.
The exception to this is writing ‘naked’ calls or puts, without owning or being short the shares respectively. This is exceedingly risky because you will be obligated to deliver shares that you do not own (for calls) or buy shares without already being short from a higher price point (for puts).
Can I “Cash out” if my option doesn’t reach the strike price?
Yes you can, as long as you sell your out of the money option before the expiration date. Remember that when an option expires it only has value if it is in the money. It does have time value associated with it before it reaches the strike price, based on the market’s assessment of the likelihood of it doing so. As expiration draws near however, buying out of the money options becomes more dangerous, simply because there is less time for the stock to reach the strike price.
In practice it’s not unusual to buy an out of the money option and sell it while it’s still out of the money, but closer to the strike price. After all, the vast majority of long option purchases are done not with the intent of eventually taking delivery of stock (for calls) or a short position (for puts), but simply to benefit from relatively fast appreciation of the premium.
Explain “time value” of stock options
The simplest explanation would be that time value equals the premium minus any intrinsic value that the option has. For example, if XYZ is trading at $12 a share and it costs me three dollars to buy an XYZ option with a $10 strike price, the intrinsic value is two dollars and the time value is one dollar.
Note that an out of the money option has no intrinsic value, so its price is comprised only of time value. As the day and hour of an option contract’s expiration approaches, the time value will, not surprisingly dwindle to nothing. This is why an out of the money option expire worthless, and why at expiration an in the money option’s value is equal to the difference between the strike price and the current price of the stock. Using our example, if XYZ is $12 per share at expiration, then the option we bought for three dollars will be worth two dollars, exactly. As a side note, remember that if we took delivery of our 100 shares at $10/share, we could immediately sell them for $12 i.e. a $200 profit.
It’s relatively easy to understand the intrinsic value of options, but investors new to options might be wondering how to precisely calculate the time value component of option. Suffice it to say that books have been written on the subject, but that much of the time-value component of an option premium reflects market expectations not of the direction the stock is likely to move but how much the stock is likely to move between now and expiration day. The word for this is volatility, and intuitively you can see how if the stock has tended to move up and down a lot recently that this will affect the market’s collective notion of the likelihood of a stock reaching a given strike price before expiration.
As high volatility in a stock, all else being equal, usually makes it more likely in the eyes of the market that its options could move enough to make their purchase worthwhile, we can expect these options to have relatively inflated premiums based on the time value component of these options being itself inflated.
I hope these answers to your questions on stock options basics have been helpful. If you have more specific questions on options trading explained please leave them in the comments; I’m confident that I can get stock options explained to anyone on this site, but it’s easier if I have specific questions to answer.