Whether you use stock options as an “insurance policy” for actual stock purposes, as a long-term substitute for owning stock, or as part of a high risk, high return short-term strategy, understanding what an option is and how it works is a must for anyone considering the use of stock options as part of their investing or trading strategy.
Disclaimer: The strategies and knowledge presented in this article are the opinions of the author and not that of a financial advisor. They are for informational and understanding purposes only, and are not recommendations to buy or sell any security. You should always do your own research before starting any investment strategy. As always, you should ensure that you are comfortable with any proposed scenarios, and understand and are ready to assume all the risks before implementing any strategy involving stocks or options.
Stock options are a contract between a buyer and seller
A stock option is a contract between an option seller and an option buyer in which the seller, in exchange for a fee (premium), agrees to buy or sell a specified number of shares (normally 100 ) of a stock for a set price (the strike price) until a specified time (expiration). These option contracts are listed and traded on an option exchange in a similar manner to stocks making it possible for buyers and sellers to purchase and sell these contracts before expiration without knowing each other. These “trades” are handled through a broker and generally require an option agreement with the broker before transactions can take place. Buyers and sellers are matched through a clearing exchange and the transaction is transparent to the buyer and seller.
Calls versus puts
An option contract that gives the buyer the right to buy shares of a stock for a set price is called a Call Option. A contract that allows the buyer to sell stock at a set price is called a Put Option. Both call and put options share some common terminology. All options have a strike price. This is the price that the underlying stock can be purchased or sold for. They also have an expiration date. That date is the last day the stock can be bought or sold under the contract.
Let’s look at an example of the most common stock option; the monthly option. If an option buyer purchases a January 2022 $50 XYZ Company call option, they are purchasing the right to buy 100 shares of XYZ Company stock for $50 per share until the third Saturday in January of 2022. Realistically, it must be done by the third Friday since exchanges are not open on Saturday. Unless stated otherwise, options effectively expire at the end of trading on the third Friday of expiration month. After expiration, the contract cannot be used to purchase or sell stock and has expired worthless if not exercised.
Exercising stock options to buy or sell stock
An option can be exercised by option buyers at any time up to expiration by letting their broker know that the option should be exercised and depositing the required amount of money (for a call) with the broker to pay for the stock purchase. The contract will be exercised and the stock purchased for the account. The option itself has been exercised and the contract fulfilled so it no longer exists. If you already own 100 shares of a stock and a put option, you can exercise the option to sell your 100 shares at the strike price of the put option. Your stock will be sold at the strike price and the proceeds of the sale deposited into your brokerage account. There may also be commissions for buying or selling the stock involved in exercising the option.
Determining option prices
Options are priced per share in the same way as stocks, keeping in mind that each option represents 100 shares. So, an option priced at $1.35 means that the share price of $1.35 is multiplied by 100 to determine the price of the option contract. In this case, the price would be $135.00 plus any commissions. Remember, this is the price (premium) to purchase the contract and is completely separate from the price to purchase or sell the stock if exercised.
The premium the seller will ask of the buyer is made up of two parts: the intrinsic value and the time value. The intrinsic value is the amount that shares of the underlying stock are currently trading above the strike price for a call or below the strike price for a put. For example, a call option with a strike price of $40 will have an intrinsic value of $5 if the stock is currently trading for $45. This value comes from the fact that if a buyer purchased this option, they could immediately exercise the option to buy the stock for $40 (the strike price) and sell the shares for $45 in the market giving them a built-in $5 profit. This option is said to be in the money by $5. Time value is determined by the time left until expiration and the volatility of the underlying stock’s price. The longer the time until expiration, the larger the time value. Time value is also affected by how much the value of the stock is fluctuating. This is the stock’s volatility. The higher the volatility, the more time value will be added to the premium since from the seller’s prospective there is a higher probability of the price reaching or remaining above (or below) the strike price. Note: if a stock is selling below the strike price, there is no intrinsic value, only time value.
Using long-term options as substitutes for owning stocks
There are a number of ways that investors use options as part of an investment strategy. One common way is as a substitute for stocks themselves. For an investor that expects the price of a stock to increase over time, purchasing a longer term call option may be a good alternative. Likewise, for an investor who expects the value of a stock to go down over time, the purchase of a longer term put option, as an alternative for a potentially high risk strategy of shorting stock (beyond the scope of this article), may be a good choice. Here’s an example.
Recently a stock was trading on the stock exchange for around $95 per share. Buying 100 shares of this stock would cost $9,500 plus commissions. The entire cost would be at risk if the price dropped to zero. At the same time, a $90 call option with an expiration nine months in the future was selling for $8.40 per share. Buying the option would cost the buyer $840 (8.40 x 100) plus commissions. The first $5 per share of the cost is intrinsic value since this option is $5 “in the money” because the stock is already selling for $5 more than the buyer has the option to buy it for ($90 strike). That leaves only $3.40 per share in time value. If the price of the stock didn’t change at all over the next nine months, that value would gradually erode away leaving the value of the option at $5 right before expiration. This is not a bad price to pay to effectively control 100 shares of a $95 stock! In addition, most of the time value will not go away until the last 90 days with the largest price erosion actually occurring in the last 30 days. This gives the buyer time to decide if the stock is moving the way the buyer expected for a relatively low cost.
The risk is also greatly reduced. The most the option buyer could lose with this trade, even if the stock dropped to near zero in value, would be the initial investment of $840. Once this option is purchased, the option will increase in value when the stock price increases and decrease when the stock price decreases. The amount will not be dollar for dollar but will be fairly close since the option is in the money. And, just like stocks, the option can be sold at any time for the current market value. This allows the buyer to participate in the underlying stock’s gains and losses without the risk of owning the stock. If the option gets within 90 days or so of the expiration date where it will begin to lose time value more rapidly, and the option holder still believes the stock will continue to rise, the option holder could “roll” the option into an option with a later expiration date for a minimal cost. This is accomplished by instructing a broker to sell the current option and buy another one with an expiration date further in the future. This can be done at a fairly low time-value cost to the buyer.
Using put options as "insurance" in a down market
Put options can be bought and sold just like call options in the previous example when the buyer believes the value of stock is going down, but another way put options can be used is as “insurance” against the drop in value of a stock or the market as a whole. When an investor owns 100 shares of stock, the entire purchase price of those shares are at risk of loss if the value of the stock goes down or the market is in a prolonged downturn. To protect against loss in this market, the shareholder might choose to purchase a put option to reduce the potential loss.
For example, if an investor purchased a 100 shares of a stock for $80 per share, the investor might also decide to purchase a put option with a strike price of $70 that would guarantee for a period of time that no matter how low the stock price went, the investor could always exercise the option and sell their 100 shares for the $70 strike price guaranteeing that the largest potential loss will be $10 per share. Purchasing “out of the money” options like this can be relatively inexpensive and the cost of this “insurance” can add peace of mind for an investor averse to risk.
This same strategy can be used to protect an entire portfolio from downside risk in the market. An investor with a portfolio of stocks can purchase put options as protection from a market downturn that affects many stocks by buying put options in an index that tracks the entire market such as the Dow or Nasdaq. Put options can also often be purchased on more specialized indexes such as technology, energy, or medical if that index represents a significant part of an investor’s stock holdings. As the value of the stocks in the portfolio decrease, the value of the put options increase, helping to offset portfolio losses.
Options can represent high risk, high return stategies
Investing in options can be a high risk investing/trading strategy that can result in a high return but usually does not for an uneducated investor. Option sellers and market makers understand market value and price options in a way that will most often result in options expiring worthless. This is important to keep in mind when investing or trading options. Using longer term options, in the money options and options to reduce risk can help reduce the risk but with countless option strategies available, education in their use is essential. This article is an introduction to what options are and a few simple ways in which they can be used. Option investors can and do lose their entire investments and should have a complete understanding of any strategy and the potential for loss before entering into an option contract. Read, study, and learn before making options a part of any investment strategy!
Disclaimer: The strategies and knowledge presented in this article are the opinions of the author and not that of a financial advisor. They are for informational and understanding purposes only, and are not recommendations to buy or sell any security. You should always do your own research before starting any investment strategy. As always, you should ensure that you are comfortable with any proposed scenarios, and understand and are ready to assume all the risks before implementing any strategy involving stocks or options.