OPTIONS BASICS

OPTIONS BASICS

WHAT IS AN OPTION?

An option is a contract that gives the option holder a right or an obligation to buy or sell a certain stock, commodity or other investment at a fixed price by some date in the future. There is a lot of information in that sentence. Let’s take things apart. And for consistency’s sake, we will talk in terms of stock options. However, there are also options on commodities and indexes.

1. Common Option Features.

a. Fixed Number of Shares. Nearly all option contracts are traded on options exchanges. These exchanges fix the number of shares covered by an option contract at 100 per contract. If you want an option on more shares, you buy more contracts.
b. Fixed Price. This price is called the Strike price. The strike prices are also defined by the exchanges. For most stocks, they are broken out $5 increments. But low priced stocks and high priced stocks have different intervals. So a stock currently trading at $62 per share may have option prices of $50, $55, $60, $65, $70 and $75 available from the options exchange.
c. Fixed Date. This is the expiration date of the option. All stock options sold in the US are “American Style” options and they can be exercised on or before the expiration date. The expiration dates are fixed and are the third Friday of the month. If the third Friday of the month falls on a Holiday, the Thursday before becomes the expiration date. If a person is the holder or owner of an option, he can exercise the option at anytime up to and including the expiration date. Or he can close out the option position, selling or buying back the option.

2. Option Types and Option Positions. An option is a contract. And like nearly all contracts, there are two parties to an option. So there are two types of options, Puts and Calls, and two parties to both a Put and a Call. Calls are the right or obligation to buy a stock at the strike price. Puts are the right or obligation to sell a stock at the strike price. Let’s stick to just Calls this Post and place the names and some faces together:

Calls. Conceptually, there are two parties to a Call. The seller and the buyer.[i] The seller of a Call enters into the option contract and obligates herself to sell her stock if it reaches the strike price before expiration. In return for obligating herself to sell her stock, she is paid a premium. The Call buyer, in exchange for paying a premium, obtains the right to buy the stock at the strike price before expiration. Let’s look at an example:

Tarzan and Jane. Jane has 100 shares of ICBM. ICBM is currently trading at $52 per share and Jane doesn’t think that ICBM will go up in the near future. So she sells a Call on her IBM stock. The Call has a strike price of $55 and in return for selling the Call, she receives a premium of 2$, or $200. ($2 * 100 shares per contract).

Tarzan believes that IBM will go up in the near future. He thinks that it could hit $65. He could buy some ICBM but instead thinks buying a Call is a more effective way of playing IBM. So Tarzan buys a Call on IBM with a strike price of $55. He pays a $2 premium for this Call.

At this point, it would look like Jane and Tarzan are each parties to the option contract. They are not, however. The Options exchange is a party to both Jane and Tarzan, both sides of the Call. But for this example, we can think of it as if Jane and Tarzan are at each side of the option. It will make the explanation clearer.

a. Tarzan Win[ii]. What can happen? If ICBM goes up to $65, Tarzan will come out ahead. Tarzan can do two things. He can exercise the option, meaning that Tarzan tells the options exchange he wants to buy his IBM shares (which are now worth $65 per share) at $55. Tarzan gets his 100 CIBM shares and he is up $8.00. Why not $10? Remember, Tarzan paid $2 for the Call, so we must consider that when he figure out his gain. ($65 ICBM market price-$55 ICBM strike price = $10. $10 ICBM proceeds - $2 Call Premium = $8.)

But Tarzan has another choice. He can sell back the option that he bought. This is called closing out the position and actually happens more often than exercise. If IBM stock rises to $65, then the value of the Call that Tarzan paid $2 for will rise. Let’s assume that the $55 dollar strike Call now sells for $10. Tarzan can sell the Call for $10 and make $8. ($10 Call Close Price - $2 Call Premium = $8.)

What happens to Jane when Tarzan wins? Two things can happen aside from tree-house abstinence. Jane can get exercised. The options exchange can tell Jane that she has been randomly selected to have her stock exercised and she must deliver her 100 ICBM shares to the options exchange. This is a result Jane may try to avoid, however. Call sellers may have large unrealized capital gains in their stock that they do not want to realize. So Jane, smart investor that she is[iii], will recognize that she was wrong on the price direction of ICBM and cut her losses. She can close out her call by buying back the call that she sold. Unfortunately, however, her $2.00 Call now sells for $.50. So she sells it back for $5 per share (.50 * 100 shares per contract) and loses $150.

b. Jane Wins[iv]. It is one month before the expiration date and so far, Jane’s belief about ICBM’s price is correct and ICBM is holding at $52. Tarzan cannot exercise his shares because his strike price is $55 and the ICBM stock is selling at $52. Tarzan can do two things. He can close out his Call by selling it or he can wait it out, hoping that ICBM will quickly rise before expiration. This is where it gets interesting. Really interesting.

Tarzan has two things working against him. First and most obvious is that fact that ICBM has not gone up in price. Second, the time left on his option is fast expiring. In the language of options, it is losing “time value”. We will go into time value more extensively in a future post, but in Tarzan’s case, his Call is running out of time to make him any money.

If Tarzan chooses to cut his losses he can close his position and sell his call. He paid $2 for the call but it now sells for $.50. So he loses $150. Or he can wait it out and hope that ICBM will shoot up on price before the Call expires in a month. But if he chooses this path, his call will fall in price as the expiration date approaches. Only an ICBM rally can bail out his losing position. If ICBM does not rally, his Call will expire worthless and he will lose the entire $200 premium he paid for the Call.

In another post we will look at Puts and how they work out.

ALL SPECIES HAVE RIGHTS IN THE DESERT OF THE REAL!




[i] Call Sellers are often Called Call Writers and Call Buyers are often Called Call Holders. But let’s stick with the definitions above for learning purposes.
[ii] Accompanied by chest beating, a jungle call, and frolicking with Cheetah.
[iii] She has to be smarter than Tarzan. That dude can’t use first-person pronouns correctly and thinks that the jungle animals understand what he yells.
[iv] Accompanied by vulgar jungle yells and a swift kick by Tarzan to Cheetah.