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 if I could explain option trading with 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.
Simply buying calls or puts is a way to leverage a relatively small amount of your investment portfolio towards a hunch that a stock will rise or fall. A call gives you the right to purchase one hundred shares of stock in a specific company at a given price point at a specific date in the future. In the same way, puts gives you the right to sell 100 shares of a company’s stock at a specific ‘strike price‘ at a predetermined future date. It’s important to recognize that you’re not trading shares of stock here; you are buying and selling the right to buy or sell shares of the stock. This is probably the most difficult concept for new investors to really understand.
Another way that stock options trading can be approached is by taking the other side of the trade from the person who buys (or “goes long”) the put or call. This is called selling, or writing, an option (you could think of it as going short the option, but let’s not get ahead of ourselves), and it’s normally a much safer trade than buying an option contract, as when you do this you are hedging with options.
The overall mechanics of an option trade will help you understand how the buyer and seller of an option take on an inverse amount of risk. This will give you a complete view of options transactions and hint at ways that they can be used as part of a conservative investment strategy as well as a leveraged financial tool. As with many things, I think a holistic overview is the best way to have stock options basics explained for inexperienced investors.
An option contract has no intrinsic value until the stock reaches the option’s strike price. The only value which the right to buy a stock at $10 has before it reaches $10 is the value of the time (time value) left before the contact expiration, during which the contract has a chance to reach the strike price. If the strike price is substantially higher than the current stock price (I’ll cover calls here) and therefore fairly unlikely to be reached by the stock before expiration, it would be unlikely for the call or put to ever have an intrinsic value, all else being equal.
If the call option is below the strike price at expiration it will expire worthless, as the value of an expiring right to buy something (today) at a price that’s higher than the current market price is zero. The option seller received money that the buyer paid for the option, known as the premium, and made the promise to deliver the 100 shares of stock at expiration. The option seller most likely owns that many shares, and if he doesn’t, his brokerage firm most certainly requires that he have funds/liquid assets with which he can use to deliver the shares. If the contract expires worthless, the option seller keeps the premium, and his 100 shares as well.
As unlikely as it may be that the option buyer will profit– and just how unlikely depends on how much time is left on the contract, how far away the stock price is from the strike price, and the stock’s volatility (propensity for the stock to move in either direction)–it is just as likely that the call or put seller will profit. Put very simply, there is an inverse relationship between the risk that option buyer assumes on one hand and the amount of risk that the option seller assumes.
It’s a truism in investing that greater risk implies greater potential rewards, but by seeing the option trade has two sides-buyer and a writer-we see that the statement that ‘options are risky’ is an overly simplistic statement. Buying puts and calls is relatively risky, but carries with it large potential rewards relative to the amount of cash one needs to buy contracts. However options selling is relatively safe–for covered options anyway–though the premium you stand to collect will be relatively small compared to the amount of stock that one promises to deliver should the contract expire in the money, ie above the strike price (in the case of calls). Less risk, less reward (though most likely more consistently achievable gains).
In other articles on this site we’ll talk in depth about using call or put purchases together with owning or being short the underlying stock, e.g using a protective put strategy to lock in stock gains.
(I should mention that I have been talking about covered calls in this example to keep things simple. Writing naked puts and calls is an extremely risky trade where the option seller does not own the underlying security. It hardly belongs in an article on stock options basics so I’ll save naked options for a separate post entirely.)
Stock Options Basic Definitions
The strike price is the price at which you have the right to buy 100 shares of the underlying stock, in the case of a call contract, or to sell 100 shares of the underlying in the case of a put contract.
The expiration date is the date on which a stock option contract expires, on Saturday after the third Friday of its expiration month. Normally options contracts for heavily traded stocks will be available to trade for the next few-or several-months from today’s date.
An in-the-money stock option is a call whose strike price is below the current price of the stock, or a put whose strike price is above the current price of the stock. We say that an in-the-money option has intrinsic value equal to the amount by which the stock price is over the strike price, times 100 (each contract covers 100 shares of stock). For example, if IBM is at $102 per share, then any of the IBM 100 series options (any expiration date) will have two dollars of intrinsic value, or be worth at least $200. Naturally the further out the expiration date of an IBM 100 series option is, the higher the value of the option will be; in this case we say that in addition to its intrinsic value it also has a time value. As you might guess, out-of-the-money options have a strike price that is below the current price of the stock in the case of calls, vice-versa for puts.
Exercising stock options is what occurs when an in the money option expires: the final holder of the option will choose to convert his contract into the 100 shares that gives him the right to purchase; in other words he “exercises his option” to purchase the shares. Remember that an out-of-the money contract will have no value at expiration and therefore cannot be exercised.
Stock options quotes are easily found in online and physical publications that focus on to the day or up-to-the-minute prices of frequently traded financial instruments. Familiar examples online are Google Finance, Yahoo Finance, and the Wall Street Journal would be a reliable place to look for options quotes if an Internet connection is unavailable.
Remember that employee stock options are issued by companies as a form of compensation, and are different from regular options that are traded on major exchanges such as the Chicago Board Options Exchange or CBOE. An overview of SFAS 123 and employee stock options basics can be found at the first link in this sentence. Also, a good review of stock option software can be found at the link.