Stock Options

Introduction.

Options are a complex tool for investors, they allow for greater leverage in long and short situations and offer protection with stock ownership. However with the misuse of options you can lose a great deal of money in a matter of hours, but with intelligent options plays you can make far more than simple stock ownership would allow you. With the complexity of options terms, pricing, and usage, it is very important to fully understand the mechanics and strategies behind trading options.

What is an Option?

An equity option represents an actual contract between a buyer and a seller, each with his or her own obligations and rights. The contract governs the purchase or sale of a given stock revolving around a specific price, called the strike price. As you never receive a piece of paper representing a stock purchase you will not receive a piece of paper to represent your option contract; the rights and obligations are assumed as soon as you purchase or sell any option. There are a few different styles of option contracts, to limit confusion from this point forward I will only be referencing American style options. If you are purchasing or selling options through any American exchange you are very likely dealing with American style options, so it seems that this would be the most relevant contract type to talk about.

There are two different types of options regarding equities, or stocks. A 'put' option is the first and moves opposite the stock price (if the stock increases in value the put decreases in value), and 'call' options which move with the price of the stock (if the stock increases in value so does the call option).

Call.

The owner (buyer) of the call option has the right (but not the obligation) to purchase 100 shares of stock at the strike price designated by the option contract. This right to buy can be exercised at any point up to and including the expiration date of the option. American style options expire on the third Friday of the expiration month.

The writer (seller) of the call option has the obligation to deliver 100 shares of stock at the designated strike price if the owner of the call option decides to exercise it. The seller of the call option may be required to fulfill this obligation at any time up to and including the expiration date of the contract. In general, if the price of the stock is lower than the strike price at expiration the option will never be exercised and will simply expire and disappear. Even if the price of the stock ventures above the strike price, call options are rarely exercised until very near the expiration date.

I will discuss strategies for using call options below, I first want to make sure I define put options as they can often be used to great benefit in conjunction with call options.  

Put.

The owner (buyer) of the put option has the right (but not the obligation) to sell 100 shares of stock at the price designated by the option contract. This right to buy can be exercised at any point up to and including the expiration date of the option. These options expire on the third Friday of the expiration month.

The writer (seller) of the put option has the obligation to purchase 100 shares of stock at the designated strike price if the owner of the put option decides to exercise it. The seller of the put option may be required to fulfill this obligation at any time up to and including the expiration date of the contract. In general, if the price of the stock is higher than the strike price at expiration the option will never be exercised and will disappear. Even if the stock price drops below the exercise price the option will probably not be exercised until very near the expiration date.

Useful Vocabulary.

• Underlying Value - Every option governs the trade of something, it could be a house, a car, or a computer. This article will cover options on equities; equity options have an underlying value of 100 shares of said stock.
  
• Exercise Price or Strike Price - The price at which the seller of the option agrees to buy or sell the underlying security. For stocks between $5 and $25 the strike prices jump at intervals of $2.50, and for stocks above $25 the strike prices jump at intervals of $5.
  
• Expiration - The day the option contract expires. Options expire on the third Friday of the expiration month.
  
• LEAPS - An acronym for Long-term Equity AnticiPation Securities. They are essentially the same as regular options but general go out as far as 12-24 months into the future. All LEAPS expire in January.
  
• Long and short - Both words have two meanings. When referring to stocks or options long refers to having purchased an option or a stock, and short refers to having sold an option, or having sold a stock short. When talking about the overall market long indicates a bullish position and short indicates a bearing position on the market.
• Holder - The buyer of an option.
  
• Bid-ask - When options are quoted two prices are given, the price at which market makers (those setting the prices) are willing to purchase the option (the bid) and the price they are willing to sell the options (the ask). The ask is always higher than the bid, this is how market makers make their money, by buying low and selling high. The difference between the bid and the ask is called the bid-ask spread. When options are fairly illiquid (not many buyers or sellers) the bid-ask is general bigger as to compensate for the risk the market maker has to take on by purchasing the options. When the option is liquid (lots of buyers and sellers) the bid-ask can be as small as 1 penny.
  
• Option Chain - The display of options on a specific equity or security. The information is generally shown in two columns, the left side listing calls and the right side listing puts.
  
• Option Premium - The price of the option contract itself.
  
• Intrinsic and Time Value - Intrinsic value is the amount by which is the option is in-the-money. The time value is the difference between the options premium and the intrinsic value. Time value decays as the option approaches the expiration date and completely disappears when the option expires. On expiration an option is worth exactly what its intrinsic value is. If you own a contract on Microsoft with a strike price of $40 and on expiration Microsoft is valued at $42.50, the intrinsic value is $42.50 and the time value is $0.00.
  
• In-the-money, at-the-money, and out-of-the-money - If an option has any intrinsic value it is in-the-money. An option is at-the-money when the price of the underlying stock is exactly equal to the strike price of the option contract. An option is out-of-the-money when it is purely time value. In context, calls are in-the-money when the value of the stock is greater than the strike price of the option. Puts alternatively are in-the-money when the value of the stock is less than the strike price of the option.
  
• Exercise - To exercise an option is to invoke the rights given by the contract. Only buyers of option contract may exercise them, however they are not under any requirement to do so.
  
• Assigned - To be assigned on an option contract is to be required to fulfill all obligations given by the sale of a put or a call. Only the writers (sellers) of options may be assigned on the contract. If you are assigned on a contract you are required by law to fulfill your duties. If you sell a call you are required, if assigned, to sell 100 shares of stock at the strike price. If you do not own 100 shares of said stock you will be required to go to the open market and purchase the required amount.
  
• Trading Volume - The volume of trades for each option in the series, these are reported in number of contracts not number of shares.
  
• Open Interest - This is the number of option contract that were opened and remained open after the end of the trading day. Open interest is only calculated after the trading day is over and always reflects the previous day. If you see open interest on Tuesday's option chain you will actually be looking at the open interest from Monday.
  
• Uncovered or Naked Option - A position in which the writer (seller) of an option doesn't hold enough equity in his account to immediately fulfill an assigned contract. If you write a call option and don't own 100 shares of said stock, you are uncovered, or naked.
  
• Margin - Essentially a loan given by brokers to cover any investment costs that the investor can't immediately pay. Margin requirement are usually given in percentages and tell you the minimum amount the investor must provide.
  
• Volatility - Volatility is one of the harder concepts in investing to understand. If you think about the most basic utility company, and then consider some of the bigger technology companies; then decide which one is more likely to increase in value by a significant amount or decrease in value by a significant amount and you will have a rough idea of what volatility is. The volatility is usually used as a measure of risk and often plays a big role in the premiums of option contracts.
  
• Buy to Open - Purchasing an option to open a position. Buying a call or a put in the most basic way.
  
• Buy to Close - Purchasing an option to close a short position. When you sell options short and would like to close the position you have to buy to close.
  
• Sell to Open - Selling an option to open a position. Selling a call or a put to open a short position.
  
• Sell to Close - Selling an option to close a long position. When you want to close a long position you have to sell to close.
  

Basic Strategies.

Buying Calls.

Purchasing a call option is the most basic bullish option strategy. Remember that when you purchase a call option you have the right to buy 100 shares of stock for every option contract you own at the given strike price. This means that if the price of the stock increases, so does the value of the option contract. Some might be wondering why you wouldn't just purchase stock. The answer is leverage, and cost. If MSFT is trading at $26, it would cost $2600 to purchase 100 shares of the stock. But say you were short term bullish on MSFT and wanted to capture as much gain as possible. One way to do that is to purchase call options. By purchasing call options you can capture the movement of all 100 shares of MSFT without having to pay the full $2600. Also, if you purchase a call option contract on MSFT and the stock sharply rises over the course of 2-3 weeks you can simple sell your options and make anywhere from 20%-100% on your investment, capturing that kind of return would be near impossible over the same time frame with simple stock ownership.

The risks involved with owning call options are a little worse on the downside. If you buy MSFT at $26 dollars and in two years it's trading at $25.90, you've only lost $0.10 a share. With options, if the stock is trading below the strike price at expiration you lose the entirety of the premium paid. The breakeven of stock being simply the price you paid for each share of stock. The breakeven on options is the strike price plus the premium paid, depending on where you purchase your options the stock price will have to move to the upside for you to just simply break even. Options come with far greater reward, but also much more risk. More often than not options are purchased with the intent of selling them rather than waiting until expiration to exercise them.

Selling Calls.

Buying Puts.

Purchasing put options is the most basic bearish strategy. The purchase of a put grants you the right to sell a stock at a given strike price. This is good for two different cicumstances. The first is very similar to purchasing call options, if you would like to use leverage and price to your advantage in a bearish situation, you could purchase put options. The basic bearish strategy for purchasing put options is almost identical to the purchase of call options except that you are investing in a decrease in the value of stock rather than an increase.

The second reason to buy puts is essentially an insurance on stock ownership. If you own 100 shares of stock and are heading into uncertain news but don't want to give up your position in the company. Say the earnings report is a week away and your stock could nose dive, or it could skyrocket, rather than give up on the upside and just sell the stock you could purchase a put option. If the stock divebombs you could exercise the option and recoup a lot of your investment. If you own MSFT at $26 and want some insurance, you could buy a put option with a strike price of $25. If the stock skyrockets, sell your put option and take the small loss. If the stock divebombs to $19, exercise your option and lose $1 a share plus the option premium instead of $6 a share. This is most comparable to insurance, it seems like wasted money, because either way you're losing AT LEAST the option premium but you're getting protection in return. No one would go without car insurance even if they expected never to be in a car accident.

Selling Puts.

Selling puts is mostly used in conjuction with other options contracts in what are called spreads. Spreads are beyond the scope of this article and will be covered in my future articles. However there is one basic use of selling puts that can be useful to the novice investor. If you would like to own stock in a company at a much lower price than it's trading for today, you could sell a put option at the strike price that you feel comfortable buying the stock. If the stock never hits that price by expiration, you walk away with the premium received. If the stock dips below that price and the option is exercised against you, you pick up the stock AND the premium. If you want to own stock, this is a great way to make a little money while waiting for the price to drop to a level you feel comfortable paying for it. The risk to making this kind of trade is that the stock price will rise, and keep on rising, potentially rising to a level you can't afford and because you set your buy target too low you missed out on all of the upside.


I hope this article was helpful in defining the basics of stock options. I will write an article on advanced trading strategies in the future so keep your eye out for that if options trading is of any interest to you.