Stock Options Explained

Maybe you have read that a stock 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 in simple terms, 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.

However, 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.

Ready? This won’t hurt at all.

It is January 1 and the price of XYZ stock is currently $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 stock 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 currently trading at $12 it is easy to see why this right to buy it at $10 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.

Does that make sense?

This 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. The intrinsic value still reflects a real, current value though.)

But 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 ($12 minus $10 in this case), 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 total premium price. An option contract has only one price but it is instructive to examine the two components of that price: intrinsic value and time value.

Let’s tweak our example above to make this all 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 (i.e. $2 above the strike price); now it’s $1 ‘out of the money‘ (i.e $1 below the strike price). 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 (and will!) happen in that time. Naturally the market will ascribe a current value to the April 10s that is more than zero, and in this case the value will be 100% time value.

I’m belaboring this example because it’s so important to understand intrinsic value and time value.

Now, 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.

If the stock is at $9 then the  price of the option contract might be 50 cents (so $50 per contract, since again each contract represents the right to buy 100 shares). If the stock is at $6 it should make intuitive sense that the right to buy at $10 would be quite a bit less, pricing again determined by the market.

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– again 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 $300, 25% on your original $1200 investment, whether it takes three days or three years to move to $15 per share.

So 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 would be $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 still $800, or 67%.
So, with the same movement in the underlying stock our profit would be 25% if we bought the stock, vs 67% if we’d bought options with the same amount of money.
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. if the concept is unfamiliar, know that taking out a home mortgage is an example of leverage.
In this way, if your position is a profitable one, your percentage gain will be higher, regardless if we are talking about options or real estate values.
The downside of leverage–of course there as to be one, right?–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 call options on it 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. Unlike stock options, shares of stock never expire…
Hopefully you can see that ‘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. Remember we paid $1200 for the position.
In this case we would lose $200 on the total position, even though we were right about XYZ!
We just weren’t right enough. And by the way, 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 by the exchange 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 15 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.

So how did I do? Please let me know in the comments if you need elaboration, and please feel free to share this article on Facebook or other social media if it helped you.

Options Trading Strategies-Two Basic Ways To Play

If you’re trying to understand option trading strategies, and terms like strike price, expiration date, time decay, and covered and uncovered calls and puts, there’s a basic understanding that you should have, an overview of stock options basics in terms of two diametrically opposed strategies, that will help you understand both buying options and selling options (aka writing options). As the scope of this site has expanded, I’ve seen that the best way for new investors to have stock options explained to them is from the perspective of option trading strategies rather than simply theoretical articles about options basics.

If you’re familiar with options only as a trading vehicle that some investors use to attempt to make huge gains very quickly, you probably have wondered what terms like “writing calls” and “naked puts” are all about. The fact is that the risky buy-side trades with which new investors are most familiar is just the tip of the iceberg when it comes to the range of ways one can use stock options to maximize the performance of their overall portfolio.

Every options transaction has a seller on the other side of the transaction from the option buyer. This makes intuitive sense, but maybe you have assumed that the option seller is an options exchange or even some large broker. This is incorrect. The fact is that anyone can sell puts and calls just as they can buy them (pending approval from your broker, who will want you to attest that you understand options well enough to approve you for trading them in the first place).

But why would I sell options, rather than buying them? The difference lies in the motivation underlying both sides of the trade. I’ll explain call options here.

Whereas the buyer of the right to buy 100 shares of stock at a given price by a given date in the future is looking for a method to leverage a relatively small amount of money for the possibility of a large percentage gain, the seller of that right is most often looking for a way to protect long stock positions that he already has in his portfolio. There is an exception to this, in the form of very risky sell-side option trading strategies known as uncovered or “naked” call or put selling, but I’ll save that stock options explanation for the end of this article to avoid confusion.

Essentially the option seller is selling the right to purchase shares that he owns at a “strike price” that he would be happy receiving for his shares, should they reach that price. Normally the seller will pick a strike price higher than where the stock is currently trading. In return, the option contract seller or writer receives a premium amount from the option buyer.

For example, if I own 1000 shares of IBM and the stock is at 140, I can sell ten option contracts of IBM 160 calls, and I will receive an amount of money from the buyer or buyers of these 10 contracts. How much money depends on how far away the expiration date is, the volatility of the stock and other factors. Should IBM be trading over 160 by the expiration date, my stock will be called away from me i.e. I will be obligated to deliver it to the buyers of the options in return for the premium that they paid me. Note that I am still happy because I experienced appreciation between the 140 level and 160, plus the premium payment, although if IBM rises to say, $200 per share before expiration I will most likely regret selling calls against my shares in the first place!

If IBM falls or at least stays below 160 strike price between the day I initiate the trade and the expiration date, then the options will expire “out of the money”, worthless. That means that I no longer have the possibility of having to deliver my shares; the transaction is concluded at the expiration date. If I’m the option seller I keep one hundred percent of the premium amount, minus commissions, and unfortunately the option buyer loses whatever he paid to enter the transaction. Regardless of where the stock price is at expiration in this situation, my cost basis for my shares has been lowered by the amount of premium that I received.

In this example the call buyer is bullish (i.e. optimistic) on the stock and the call seller is bearish, or at least not overly bullish (after all he’s not bearish enough to sell his shares). It might have occurred to you that just as a put buyer is bearish on a stock that the put seller must be bullish (or at least not excessively bearish). This is an accurate assumption. This implies that ultimately one can’t think of either buying or selling options as bullish or bearish trades, as you could be a call buyer or put seller if you were bullish-to-neutral, and a put buyer or a call seller if you were bearish-to-neutral.

Options selling versus buying is more properly thought of in terms a risk/reward profile that a person wants to assume when he makes a trade. The buyer of the put or call is prepared to lose much or all of the premium he pays if the trade goes against him in return for the possibility of relatively large gains very quickly. The seller of a put or call is interested in making a relatively small profit on an open position where he is either long or short the stock, often with the only potential downside being the opportunity cost of having his stock or short position terminated at expiration if the option is in-the-money. Either way, the option buyer buys risk; the option seller is hedging with an eye on security and a smallish gain.

Well, as with many things, good way to explain option trading strategies is in terms of a dichotomy. Reality has exceptions, and options trading also has an interesting exception to the buy risk/sell to hedge opposing strategies.

I promised to explain one way in which option selling is very risky; this option trading strategy is actually much riskier than buying options. Selling covered calls means that you own the stock against which you write the calls. Selling “naked” calls means that you do not own the underlying stock if you are selling calls, and if you are selling “naked” puts, that you are not short the underlying security.

Wait a minute. How can anything be riskier than the possibility of losing your entire premium amount when you buy a put or a call? Here’s how naked option selling works on the call side (fasten your seatbelt!):

In our initial example of selling IBM 160 calls against shares that we own when IBM is trading at 140, the premium we received functioned as a hedge against a possible downward move in the stock. Believe it or not is perfectly legal to take the premium from the call buyer without owning any shares of the underlying stock. Should the stock close at expiration below 160, the call seller keeps his premium without having to have taken any further position, i.e. lay out any money for the shares of stock, as the seller of a covered call does. Assuming that the writer of a naked call holds his position until options expiration, you can say that he has an infinite return (minus commissions of course!). Sounds wonderful doesn’t it? And so what happens in the event that the stock is trading above the calls’ strike price at expiration?

The naked option seller is required to deliver 100 shares of stock per contract that he has sold. The premium he has received is miniscule compared to the amount of money he needs to pay for a stock position that he will establish at the strike price. In our example above, the naked seller needs $160,000 to buy 1000 shares of IBM at 160 to fill his obligations. You don’t need to do much more than read that sentence again to understand the amount of risk a naked options seller is assuming.

Now in practice, online brokers-in addition to furnishing you with stock option software-require you to maintain equity in your account to cover obligations that you have in delivering stock that you might be obliged to deliver. Still, the possible downside from this trade is such that even though one does not have to purchase shares, you must be psychologically and financially prepared to do so. Needless to say, writing naked puts or calls should only be attempted if you are an experienced options trader, and it is one of those options trading strategies in which most investors will never participate.

My hope is that you have found a fairly comprehensive overview of the two basic strategies for options trading explained here. Please let me know if you would like further elaboration in the comments.