Whenever a new product or idea is created, there are always variations designed to fill different needs that will follow. For example, when the automobile was first invented, it answered the broad question of transportation. But once the working model appeared, other people made modifications to resolve slightly different problems. Since the automobile's invention, we've seen many variations such as trucks, SUVs, compacts, hybrids, and others through the years come to market. While they are all forms of transportation, they fill different needs.
The financial markets are no different from other products. As new products come to market, modifications are made in order to solve slightly different problems. One of the more popular inventions is a set of assets called options.
In order to appreciate the value of options, you need to consider the pros and cons of stock investing. If you buy shares of stock, you are buying a piece of the company. And with that purchase comes the potential for high rewards. Many investors who bought shares of Microsoft when it was first offered in 1986 are millionaires many times over today. But with that potential for high reward also comes the potential for high loss. In early 2001, Enron was regarded as a market leader in the energy trading business and one of the largest corporations in the world. Later that year, it filed for what was to become the largest bankruptcy in United States history. Many investors lost their life savings by investing in Enron.
So are stocks good or bad? Obviously, it depends on what happens to the stock but that is something we cannot know beforehand. In other words, there is risk associated with stock investing. In order to make the financial markets run smoother, options were created to manage the risks and rewards of stock investing, which is a good thing.
However, if you talk to investors or traders about options you will find there is no financial asset that is more misunderstood than options - and there is good reason for the misunderstandings. To some investors, the word "options" relays the feelings of risk, gambling, speculation, and reckless investing. To other investors though, options means hedging, safe, insurance, good money management, and prudent investing. How can the same asset cause two completely opposing thoughts? The reason is that both views can be correct; it just depends on how you're using the options. Credit cards are a good example. One person can use them to spend excessively and end up in bankruptcy while another uses it to pay for an emergency auto repair after being stranded at midnight on a deserted road. Are credit cards good or bad? Just as with options, it depends on how they are used.
The options market was designed to let investors buy and sell risk. In doing so, the stock market can run smoother and more efficiently. The options market is a necessary addition to manage the growing complexities involved with stocks. The options market works on a simple principle in that, while many investors wish to reduce risk, there are some people who actively look for risk. These people are called speculators. Speculators are willing to gamble for big profits; they aren't afraid to take a long shot if there is a potential for big money. People who patronize casinos and play state lotteries are acting as speculators. If there are speculators out there who are willing to accept risk, wouldn't it make sense to be able to sell them some? In other words, it would be nice if we had a way to transfer some of the unwanted risk associated with stocks over to those who do want the risk. Of course, in order to make it worth their while, we will have to pay them some money to accept that risk. So if there is a risk you wish to avoid, you can do so by purchasing an option. Conversely, if there is a risk you're willing to assume, you can get paid through the options market to accept the risk for someone else. So while one investor may be using options to avoid risk, it is possible that the person on the other side of the trade is a speculator in search of greater profits. Investors who do not understand this interplay between investors and speculators hear both sides of the story and that's where the confusion comes in.
Unfortunately, this confusion often makes many investors avoid options altogether. And this is a big mistake in today's marketplace. As our economies expand, our financial needs increase and that's why you see so many new financial products coming to market. They are all different and each one provides the solution to a problem. If you choose to not learn about options, you are overlooking what may be the most important and powerful investment tool available to you. Options allow you to selectively pick and choose the risks you want to take or avoid, which is something that cannot be done with any other financial asset. At least take the time to understand them; you can always elect to not use them.
Chances are that you're reading this because you're new to options. If so, you've come to the right place. We just ask that you approach them with a clear mind and forget everything that you've heard about them in the past - chances are it is wrong or very misleading. As many times as we've presented introductory seminars to options, it never fails that the investors who thought they would never use them are the ones who come up with the most questions because they see so many possibilities. We are quite confident that you will find at least one beneficial use that you never knew existed. And if that's all you get out of this, at least it's more than what you started with.
We'll take you through the basics of options in a way that is easy to understand. At the end, you will know if they're right for you or not. So with that, let's get started!
What is an Option?
There are two types of options: calls and puts. A call option gives the owner the right, not the obligation, to buy stock at a specific price over a given period of time. In other words, it gives you the right to "call" stock away from another person. A put option, on the other hand, gives the owner the right, not the obligation, to sell stock at a specific price through an expiration date. It gives you the right to "put" the stock back to the owner. Options only convey rights to buy or sell stock. If you own an option, you do not get any of the benefits that come with stock such as dividends or voting privileges. Options are simply agreements between two people to buy and sell stock.
While options may sound complicated and appropriate only for sophisticated investors, they are quite easy to understand and actually quite commonly used in everyday life - although they are called by different names. In fact, we're sure that everyone reading this has used a call or put option at one time or another. If you don't believe it, keep reading!
You're probably thinking that you've never used anything remotely close to a call option but think about the following:
A pizza coupon? Yes, that's really all a call option is. The above coupon gives the holder the right to buy one pizza. It is not an obligation. You use the coupon only if you choose to do so. Notice we've been saying that the owner has the right - not the obligation - to buy stock (with a call) or sell stock (with a put). In other words, it is your option to choose what to do with it and that's where these assets get their name.
Put options, on the other hand, can be thought of as an insurance policy. Take, for example, your car insurance. When you buy an auto insurance policy, you really hope that you will not wreck your car and that the policy will "expire worthless." However, if you should total your car, you can always "put" it back to the insurance company in exchange for cash. Put options allow the holder to "put" stock back to someone else in exchange for cash. It is important to remember that buyers of options, whether calls or puts, have rights, not obligations.
Sellers of options, on the other hand, have obligations. They have an obligation to fulfill the contract if the call or put holder decides to use their option. If you sell a call option, you have the potential obligation to sell stock. If you sell a put option, you have the potential obligation to buy stock. You have a "potential" obligation since you do not know whether or not the buyer will use the option. Notice that the buyers and sellers are on opposite sides of the deal. The call holder has the right to buy while the call seller has the obligation to sell. This arrangement is necessary in order for it to work. First, we have a buyer matched with a seller of the call. Second, if the call buyer wishes to buy stock, we know the deal will go through since the call seller has the obligation to sell stock. The put buyer has the right to sell stock, while the put seller has the obligation to buy stock.
Long and Short
If you own a call option, you are "long" the option ("long" is just a market jargon meaning that you own it). If you sell an option, you are "short" the option ("short" is just market jargon meaning that you sold something you don't own and will have some sort of obligation. By selling it, you receive money up front for accepting the obligation).
The following table might help to understand the rights versus obligations relationships:
Using our pizza coupon example, if you are holding the pizza coupon, you are "long" the coupon and have the right to buy one pizza. The pizza store owner would be "short" the coupon and has an obligation to sell if you choose to use the coupon. In the real world, pizza store owners do not receive money for their coupons; they are handed out for free (we'll find out why later). But in the real world of options, the seller does receive money from the buyer in exchange for accepting that obligation.
Using the insurance example for put options, if you buy an auto insurance policy, you are "long" the policy and have the right to "put" your car back to the insurance company. The insurance company is "short" the policy; they receive money in exchange for the potential obligation of having to buy your car from you.
Before we can understand how to use options, we need to cover some additional terminology.
In the coupon example, we would say the underlying asset is a pizza. Notice that we are limited to how many pizzas we can purchase; we cannot purchase all we want. The underlying asset for a call or put option is 100 shares of stock. The value, or price, of an option is tied to, or derived by, the underlying asset. Because of this, options are considered to be one of many types of derivative instruments. A derivative instrument is one whose value is derived by the value of another asset.
The pizza coupon also states a specific purchase price of $7.99. No matter what the price of pizzas may be when you get to the store, you are locked in to the price of $7.99. If this were a call option, we'd call this "lock in" price the strike price, which is really a slang term that got its roots from "striking" the deal at that price. Notice too that the coupon also has an expiration date. You can use this coupon at any time up to and including the expiration date. After that, it's no longer valid.
The pizza coupon simplifies the idea behind a call option. Notice that the pizza coupon gives the holder the right, not the obligation, to buy a specific amount of the underlying asset for a fixed price over a given period of time, which is our exact definition of a call option. The major difference between a real call option and a pizza coupon is that you must buy the call option while pizza coupons are handed out for free. The price you pay for an option, whether a call or put, is called the premium. (Note that the term used for the price of an auto insurance policy is also the premium. There really are lots of similarities between puts and insurance!)
While the pizza coupon gives you the right to buy one pizza, call options give the owner the right to buy 100 shares of the underling stock. If you have a $30 Microsoft call option, you have the right, not the obligation to buy 100 shares of Microsoft stock for $30 per share. Just like the pizza coupon "locks in" your purchase price, so does the call option. This call gives you the right to buy 100 shares of Microsoft for a fixed price of $30 per share - no matter how high that stock may be trading. You are locked into that price if you choose to use the coupon.
Because you can buy 100 shares of stock, the premium of the option must be multiplied by 100 in order to find the total cost of the option. For instance, your broker may tell you that a $30 Microsoft call option costs $4 (again, that is the premium of the option). But what the broker really means is that it costs $4 per share. If you wish to buy the call, you must pay $4 * 100 shares = $400 plus commission to buy one contract. You would pay $800 for two contracts and so forth. Now, if you choose to use your coupon and buy 100 shares of Microsoft, that would cost $30 strike price * 100 shares = $3,000 plus commissions.
Put options work the same way as call options but in the reverse direction. With an insurance policy, you have a stated value that you are insuring. You may get a $30,000 auto policy or a million dollar home policy. That's similar to the strike price. The insurance policy has an expiration date and specifies what is being insured. If you buy a $30 Microsoft put option, you have the right, not the obligation, to sell 100 shares of Microsoft for $30 per share. If your broker tells you the put costs $2, then the total cost is really $2 * 100 shares = $200 plus commission. If you use your put to sell your Microsoft shares, you will receive the strike price of $30 * 100 shares = $3,000 less commission.
Options are standardized contracts. This means they must conform to certain specifications. For example, there are only a limited number of strike prices we can choose from as well as expiration months. In most cases, stock options are available in a limited range of $5 increments. So for Microsoft, you may find a $25 call, $30 call, $35 call, and so on.
Pizza coupons and auto policies, on the other hand, are not standardized. They can be written to expire anytime the store owner or insurance company wishes and can be made to control two or more pizzas or cover numerous autos. They are completely flexible. Technically, there is nothing illegal about two people having a contract drawn up by an attorney that specifies the terms on which they agree to buy and sell stock. You could therefore have an attorney write a contract for you and another thus creating your own call or put option. A contract drawn in this manner is completely flexible - but it is also very time consuming and costly. In addition, even though you may have a legally binding contract, it is possible that the seller decides to not fulfill their obligation if the buyer wishes to use their option. If that happens, now you've got your hands tied up in court trying to get them to conform to the terms of the contract. With standardized options though, the Options Clearing Corporation (OCC) stands between each buyer and seller and guarantees that delivery will be made if you choose to use your coupon. By using standardized contracts, we lose some flexibility in terms (such as strike prices and expiration dates) but increase the ease, speed, and security in which we can create the contracts. Because options are binding contracts, they are traded in units called contracts unlike stock which is traded in shares. While it may sound like a time consuming, complicated process, you can buy one option contract just as quickly as you can buy 100 shares of stock. You place the order and in seconds the order is filled.
One of the most important aspects about options is that they expire at some point. While you can generally find options with expiration dates as short as one month and as long as three years, they all expire on their expiration date. You can buy and sell contracts at any time prior to their expiration date. The expiration date is very easy to find; it is always the third Friday of the expiration month and year. Technically speaking, equity options (that is, options on stock) expire on Saturday following the third Friday but that is really for clearing purposes. That extra day gives the OCC time to match buyers and sellers while the contract is still legally "alive." But as far as trading is concerned, the last day to buy, sell, or use your option (to buy or sell the stock) is the third Friday. The third Friday is always the last day to trade; it's one of the limitations of having a standardized contract. There are some index options, such as options covering the S&P 500 Index that expire on the third Thursday of the expiration month. But if you're trading stock options, the last day to trade the option is the third Friday of the expiration month.
Understanding a Real Call Option
Okay, we have enough of the basic terminology to understand real call and put options so let's take a look at an example using real eBay option quotes in Figure 1:
Figure 1: eBay Option Quotes
The call options are listed on the left while the put options are listed on the right. These quotes were
taken from the Chicago Board Options Exchange (CBOE), which is the largest options exchange in the
world. You'll find that most of the option contracts you trade will be filled at the CBOE. You can read more
about the CBOE or find other option quotes at www.cboe.com.
At the time these quotes were taken, eBay stock was trading for $93.60, which you can see in the upper right corner of Figure 1. The first call option in the list is 04 Oct 80. The "04 Oct" tells us that the contract expires in October '04 and the "80" designates that it is an $80 strike. The last trading day for this option will be the third Friday in October '04. All you have to do is look at a calendar and count the third Friday for Oct '04 and that is the last day we can trade the option (this happens to be Oct 15). All 04 Oct options will expire on this date regardless of strike price or whether they are calls or puts.
The 80 strike, again, means that the owner of this "coupon" has the right, not the obligation, to buy 100 shares of eBay for $80 through the third Friday of Oct '04. No matter where eBay may be trading, the owner of this coupon is locked into an $80 purchase price. Now this seems like a pretty good deal since the stock is trading for $93.60. It appears that if you got the $80 call, you could make an immediate profit of $93.60 - $80 = $13.60. In other words, if we could get our hands on this coupon, we could buy the stock for $80 and immediately sell it for the going price of $93.60 thus making a $13.60 profit. However, you must remember that call options, unlike pizza coupons, are not free. How much will it cost to buy this coupon? If you look at the "ask" column, you'll see that it will cost $14.30 to buy the call, which means the free $13.60 is no longer free. In fact, you will find that you must always pay for any immediate advantage that any "coupon" conveys. Remember, the $14.30 price (or premium) really means it will cost $14.30 * 100 = $1,430 plus commission to buy this contract. Two contracts (200 shares) would cost $2,860 plus commissions etc.
Let's try the next one on the list, which is 04 Oct 85. If you buy this call option, you have the right, not the obligation, to buy 100 shares of eBay for $85 per share through the third Friday in May '04. Since eBay is trading for $93.60, we know that anybody holding this option has an immediate advantage of $93.60 - $85 = $8.60 by holding the call and we now know that this advantage must be reflected in the price. You can verify that the asking price is $9.80, which means the apparently free $8.60 benefit is not free. If you want to buy this contract, it will cost you $9.80 * 100 shares = $980 per contract + commissions.
You may be starting to see some advantages of options. If you want to buy 100 shares of eBay, you must pay $9,360 and you could possibly lose nearly that entire amount. Instead, you could buy the $85 call option and pay only $980 but still control 100 shares. The worst that could happen is for the stock's price to fall below $85 by expiration thus making the call option worthless to you and you'd be out $980. This limited downside risk is one of the biggest advantages of call options. Why would the $85 call be worthless? If the stock's price is below $85 at expiration and you wanted to buy the stock, you'd just buy the stock in the open market and not use your coupon. Think of the pizza coupon analogy. If you have a coupon that gives you the right to buy one pizza for $10 but, when you arrive at the store, you find the same pizza is selling for $9 on special, what would you do? Now there's no use in using the coupon and you'd just let the coupon go and buy the pizza without using the coupon. The same idea is true for call options. If you wish to buy the underlying stock and the stock is trading at a "better deal" than what your strike price allows, you just forget about your call option and buy the stock. Remember, it is your right to use the call option if you wish; you are not required to use it. Options allow traders to capitalize on up or down price movements in the stock but only expose them to a limited amount of risk.
Understanding a Real Put Option
In Figure 1, the Oct 80 put option gives the buyer the right to sell 100 shares of eBay for a price of $80 per share. Why would someone want this right when the stock is trading for over $93? Because the $80 strike price is so far below the stock's price, anybody buying this put is really buying it for "disaster" insurance. You can think of it as someone who wants $80 of insurance of something that is worth $93. In other words, the person is assuming the first $93 - $80 = $13 worth of risk, which is similar to a deductible for insurance. If you have a $200,000 home but only want coverage for $195,000, you are accepting a $5,000 deductible and assuming that first $5,000 in risk. In exchange for assuming some of the risk, you will pay a lower premium. Similarly, the $80 put holder is willing to assume the first $13 in "damage" and, in exchange, will pay a lower premium. Notice that the $80 put is the cheapest of all since its strike is furthest below the current stock price. As you increase the level of the insurance with your insurance agent, the price goes up and the put option market is no exception. Notice that the puts get more expensive as the strike price increases. The holder of this put can always sell his stock and receive $80 per share through expiration. By holding this put, the trader knows this is the worst that could happen. What will it cost for this protection? We see the premium is 60 cents, or 0.60 * 100 = $60 plus commissions per contract. The Oct 85 put will cost $1.15 * 100 shares = $115 plus commissions and the owner is guaranteed to receive $85 per share for his stock through expiration if he chooses to use the put option.
Just as with call option, a put option's price must be worth any immediate value it conveys. For example, the $100 put is apparently very advantageous to hold since it gives the holder the right to sell eBay for $100 rather than the current price of $93.60, which gives an immediate benefit of $100 - $93.60 = $6.40. Notice that the put costs $7.50, which means the "free" $6.40 benefit is no longer free. The put will always be worth any immediate value it conveys, just like call options.
You've got the basics of how call and put options work! Now let's take a look at some more terminology and mechanics of options.
Strike Price Increments
Notice that the call and put strikes are available in $5 increments, which is true for most stocks. If the stock's price is below $25, you will find options available in $2.50 increments. And if the stock's price is over $200, you will find option strikes in $10 increments. But because most stock prices are between $25 and $200, most options will be listed in $5 increments. Also, at the time Figure 1 was taken, there were many more strikes available that what is shown. We just shortened it to make the list more manageable. It just so happens at this time that the highest strike for October was $115. It is up to the CBOE to decide on which strikes they think are needed by the market. Because eBay is trading for $93.60, you will probably not find a $150 strike expiring in the next couple of months, but you may possibly find out two-years out. There is always a paired call and put for every strike price.
More Time Means More Money
In Figure 1, you may have also noticed that the longer term calls and puts are more expensive. For example, the 05 Jan $80 call is $17.40 while the 04 Oct $80 call is $14.30. Why does the January option cost more? The reason is that the January call allows more time for the option to become valuable. Since all other factors between the two calls are the same, traders are only bidding up the value of the additional time. Why $3.10 extra value? That's a question for which we will never know the answer. That is up to the market to decide; it's up to people like you and me. Every day we place orders to buy and sell options, we're either putting upward or downward pressure on their prices. At the time these quotes were taken, the market was placing $3.10 cents extra value on the January $80 call over the October $80 call. We can be sure that longer term options will always cost more than shorter term options but we cannot be sure by how much. With all else constant, longer term options will cost you more money.
The letters XBAJP-E listed after 04 Oct 80 call represent the symbol for that option. Just as you need a symbol to buy a stock or mutual fund, you need a symbol to buy an option. For the October $80 call, XBAJP is the symbol. The dash "E" after the symbol is the CBOEs designation for their exchange; in other words, it shows the quotes are coming from the CBOE.
You Don't Ever Have to Purchase Stock
It is important to understand that if you buy call or put options, you do not have to have shares of the
underlying stock in your account nor do you ever need to buy or sell shares. Most option contracts are opened and closed in the open market without a single share of stock changing hands. Even though you're allowed to purchase or sell stock with your options, most traders never do. Instead, they just buy and sell the contracts in the open market amongst other traders.
This is a great advantage of trading options since they allow you to participate in the movements of the underlying stock without having to have the full amount of cash. For example, assume you buy the eBay $95 call in Figure 1 for $2.90, or $290 for one contract. Now assume that eBay moves up to $100. Because there is a $5 advantage to the owner of this coupon, the $95 call must be worth at least $5. This means you can just sell the $95 call in the open market and receive at least $500 for it thus leaving you with at least a profit of $500 - $290 = $210, or 72%. Notice that if you had wanted to invest in eBay, you would have had to pay $9,360 to buy 100 shares. But because of the options market, you can now invest in 100 shares of eBay for only $290. The big difference between the two choices is that the stock never expires while the option certainly does. Even though you only pay $290 to buy the call, you could end up losing 100% of the investment if the stock's price does not move sufficiently in your favor by expiration. We'll show you how to figure where that point is at a later section when we talk about breakeven points.
Exercise vs. Assign
If you wish to use your call or put, you must call your broker and submit exercise instructions. This means nothing more than telling him that you wish to use your call option to buy stock or your put option to sell stock.
If you exercise a call option, three business days later you will receive 100 shares of the underlying stock in your account for each contract you exercise and, at the same time, will pay the strike price * 100 shares, which is called the exercise value of the contract. For example, assume you had purchased the eBay $90 call and now wanted to exercise it. You would call your broker and say, "I'd like to exercise my eBay $90 call." That's it. Three business days later you will receive 100 shares of eBay and your account will be debited for $90 * 100 shares = $9,000 + commissions. (Most brokerage firms charge the standard stock commission to exercise an option.) If you exercise a call, you receive shares of stock in exchange for cash. The exercise value of this contract is $90 * 100 = $9,000 per contract.
If you exercise a put option, three business days later you will lose 100 shares of the underlying stock and receive the exercise value of the contract. If you exercise a $90 put, your account will be debited for 100 shares and you will be credited $90 * 100 shares = $9,000 less commissions.
Because the strike price is the price you pay if you exercise your option, it is also referred to as the exercise price. So if you hear the words strike price or exercise price they mean exactly the same thing.
We just found out how the long call or put holder can exercise their options. What happens to the person who sold the call or put? That person is required (remember, the short option has an obligation) to sell shares (if they sold a call) or buy shares (if they sold a put). The short position is said to be assigned. If you are short a call, you have no rights; you have an obligation to deliver the shares if you are assigned. If you were the one who sold the eBay $90 call, you could receive an assignment notice requiring you to give up 100 shares of eBay in exchange for $90 per share, or $9,000 cash less commissions. Your broker will notify you the next business day to inform you on an assignment. This is just an informational phone call and there is nothing you need to do. Your broker may say something like, "Just letting you know that you were assigned on the eBay $90 call and have sold 100 shares for $90 per share." If you sell a $90 put, you could receive an assignment notice through your broker and be required to buy 100 shares of stock for $90 per share.
Intrinsic Values and Time Values
We said earlier that an option's price must trade for a minimum amount if there is an immediate value in holding it. To really understand intrinsic value, it helps if you learn to substitute the word "immediate benefit" or "immediate value" for intrinsic value. For example, the holder of the eBay $90 call has an immediate benefit of $3.60 by holding the call since the current stock price is $93.60. This immediate benefit is called the intrinsic value. In other words, it is value that can be readily determined. If there is any value over and above this amount, it is called time value or time premium. The time value is due to the fact that there is still time remaining on the option.
Any option's price can be broken down into the two components of intrinsic values and time values. We just determined that the eBay $90 call has an intrinsic value of $3.10; however, its price is $5.90. This means the remaining value of $5.90 - $3.10 = $2.80 is due to time value. If this $90 call were to expire this very second, the time value would be zero and the option would only be worth the $3.10 intrinsic value. It is only the time value portion of an option's price that gets chipped away with the passage of time. Some people will tell you that all options expire worthless and that's not true. It's only the options with no intrinsic value that are worthless at expiration. Of course, any option with intrinsic value can expire worthless too - but that's due to the stock moving adversely and not because time has passed.
Okay, let's try another one. Can you break down the Oct $85 call into intrinsic and time values? The holder of the Oct $85 call has an immediate advantage over someone who just buys the stock for the current price of $93.60. How much of an advantage? It is a beneficial difference of $93.60 - $85 = $8.60. Therefore, $8.60 is the intrinsic value. Since the Oct $85 call is trading for $9.80, the remaining portion of $9.80 - 8.60 = $1.20 is time premium. The Oct $85 call would only be worth $8.60 if it were to expire today. But because there is time remaining, market participants are willing to bid the price higher by an additional $1.20. Again, that $1.20 figure is determined by the market. It's just a value that exists in the minds of traders. We don't know why traders are paying $1.20; we just know that they are. All options must fully reflect their intrinsic values but the time values can vary greatly.
Notice that the intrinsic value plus the time value equals the total value of the option. We just figured out that the Oct $85 call has $8.60 intrinsic value and $1.20 time value. Therefore, the total cost of the option must be $8.60 + $1.20 = $9.80.
For those who like mathematical formulas, you might remember intrinsic value better with this: Stock price - Exercise price = Intrinsic Value (assuming you get a positive number). If the number is negative, there is no intrinsic value. For instance, if we're trying to figure out the intrinsic value for the $85 call, we'd take the $93.60 stock price and subtract the $85 strike price, which gives us a positive $8.60. Since this is a positive number, we know this is the intrinsic value. However, the $90 call has $90 - $93.60 = -$3.60. Since this is a negative number, there is no intrinsic value.
There is an alternate formula you may find useful too. That is, Premium - Intrinsic = Time. The May $85 call's premium is $9.80, of which $8.60 is intrinsic value. Therefore, $9.80 - $8.60 = $1.20 in time value.
If there is no intrinsic value in an option, then its entire price is due to time value. For example, the Oct $95 call is trading for $2.90. Since there is no immediate benefit in holding this option, there is no intrinsic value. In other words, if you wanted to buy the stock, you'd rather pay the current price of $93.60 rather than buy the option for the right to pay $95. On the surface, it may seem that the $95 option has no value. That's partly true. But the real way to say it is that it has no intrinsic value; the $95 call has no immediate value.
For the Oct $95 call, the entire $2.90 premium is made up entirely of time value. If this option were to expire immediately, it would be worthless and you would lose 100% of your investment. So why would anybody buy the $95 call? The main reason is due to downside protection. If you buy the $95 call, or any call option for that matter, the most you could lose is the amount you paid, which is far less than what you will pay for the stock. And because the $95 call is one of the cheapest calls, there are many traders who want to buy it so that they only have a little bit of money at risk.
For example, assume you buy 100 shares of eBay and spend $9,360. You could theoretically lose it all even though that is an unlikely event. Still, it is a lot of money that could potentially be lost. However, if you buy one of the call options, the most you could lose is the amount you paid. If you buy the $85 call, the most you could lose is $980 + commissions. If you buy the $90 call, the most you could lose is $590. And, as we just saw, the most you could lose with the $95 call is $290. Why, then, would anybody buy any call option other than the cheapest one available? The reason is that all options do not behave the same when the stock price rises. We'll talk more about this later but, for now, just understand that you're not comparing apples to apples when you look at the various strike prices of options.
It is very important to understand how to break an option's price into intrinsic and time values as you get into strategies. The reason is that it is the time value that wastes away with time and not the intrinsic value. You need to know how much of each value is present in your option.
Because options lose some value with each passing day, options are called wasting assets. There are some traders who refuse to use options because of the fact that part of the option's price deteriorates over time. But that is a shortsighted reason. The car you drive loses value over time. The same is true for the fruits and vegetables that you buy. What about the computer you use? So it doesn't make sense to say that it's not worthwhile to invest in an asset whose value depreciates over time. You just have to be careful in the way you use them. If you think about it, most assets you buy deteriorate over time so don't back away from options just because of a portion of their value depreciates over time. Even the expensive factories that General Motors is using are losing value with each day but the CEOs would tell you they have been very productive assets.
Option strikes are generally classified as in-the-money, out-of-the-money, or at-the-money. An option with intrinsic value is in-the-money while an option with no intrinsic value is out-of-the-money. An option that is neither in nor out of the money is at-the-money. For example, in Figure 1, the $85 call and the $90 call are in-the-money since both have intrinsic value. Both coupons give the holder the right to buy the stock for less than it is currently trading. The $95 call is out-of-the-money since there is no immediate benefit in holding it; there is no intrinsic value. Technically speaking, an at-the-money option has a strike that exactly matches the price of the stock. But since that is pretty rare, we usually call the at-the-money strike as the one that is closest to the current stock price. In Figure 1, we'd say that the $95 strike is the at-the-money call option.
For the put options, all strikes higher than the stock's price are in-the-money. In Figure 1, they are the $95 and $100 strikes. Most option exchanges, such as the CBOE, always maintain at least one in-the-money and one out-of-the-money option for each month. In general, in-the-money options will have a small time premium and so will out-of-the-money options. At-the-money options have the greatest amount of time premium associated with their strikes.
The terms in-the-money, out-of-the-money, and at-the-money are sometimes referred to as the moneyness of an option. These terms are used just for description purposes; it just makes it easier for option traders to describe types of options and strategies. For example, rather than tell someone that you are currently looking at "call options whose strike prices are lower than the current value of the stock," it's easier to say you are considering in-the-money calls.
The following diagrams may help you to understand the differences in the moneyness of calls and puts:
Options Must be Worth at Least Intrinsic Value
When an option expires, it is worth one of two values: It is either worth the intrinsic value or it is worth nothing. Many people think that all options expire worthless at expiration and this is definitely not true. It is only the time value of the option that becomes worthless. If there is any intrinsic value it stays with the option!
How do we know that an option has to be worth at least intrinsic value? Think back to the pizza coupons. Imagine that pizza coupons do have value and they are traded in the streets (the marketplace). Now assume that pizzas are $20 and a $10 coupon is only selling for $5. We know that it "should" be worth $10 since that is the intrinsic value. Can anything be done about this? The answer is yes. The way the market corrects for this missing value is that enterprising individuals would buy the pizza coupon for $5 and then take it to the store and buy the pizza for $10. They would have spent a total of $15 to get the pizza ($5 for the coupon + $10 for the pizza). Then they'd walk out in the street and sell the pizza for $20, thus making a $5 guaranteed profit. As individuals figure this out, they will compete in the market for these coupons thus raising their price. At what point will the competition for coupons stop? When the price of the coupon reaches $10, which is the intrinsic value.
All options must trade for their intrinsic value otherwise a similar set of transactions would take place in the market by arbitrageurs, which are people who look to capitalize on mispricings just like these. For instance, assume that the Oct $90 call was trading for $2 in Figure 1. We know that it "should" be trading for at least the intrinsic value of $3.60, which means there is a minimum missing value of $1.60. Arbitrageurs would buy the call and simultaneously sell the stock. They will spend $2 on the call but receive $93.60 from selling the stock, which leaves them with a net credit of $91.60. They also must buy back the shares they are short, which they would do by purchasing with the call option for $90, which leaves you with a free profit of $91.60 - $90 = $1.60, which is exactly the amount of missing intrinsic value. The arbitrageurs' actions put buying pressure on the call and selling pressure on the stock. Obviously, they would continue to do this as long as the "free money" is available; that is, until the intrinsic value is restored. The moral to this story is that arbitrageurs provide a very important economic function in that they assure that option prices will always reflect intrinsic value for the rest of us.
We said earlier that the underlying stock must move sufficiently in your favor in order to make money. How far is sufficiently? That's easy to figure out. For call options, all you have to do is add the price you paid for the option to the strike price and that's how far the stock's price must move by expiration in order to break even. For example, if you paid $2.90 for the eBay $95 call, then the stock must get to $95 + $2.90 = $97.90 at expiration in order for you to break even on the trade. If you understand the previous section about intrinsic values, you will understand why. If the stock is $97.90 at expiration, then the $95 call must be worth the intrinsic value of $97.90 - $95 = $2.90. This means you could sell the call for $2.90, which is the exact amount you paid and therefore you would just break even. (In the real world of trading, the bid-ask spread will actually make this value a little less.) Now, prior to expiration, you could break even without the stock's price moving to $97.90. The reason is due to the time premium. For example, assume that eBay moves from $93.60 to $95 tomorrow. You might see that $95 call trading for $4, which means you could sell for a nice profit. Remember, we have no way of knowing what price the market will bid for the time premium so it's certainly possible you could make a profit without the stock's price ever hitting the breakeven point. Still, the breakeven point is a good guideline for the risk associated with a particular option.
For put options, the breakeven point is found by subtracting the price you paid from the strike price. If you bought the eBay $95 put for $4.30, then the stock must fall to $95 - $4.30 = $90.70 at expiration in order for you to break even on the trade. With the stock at $90.70, the $95 put must be worth the intrinsic value of $95 - $90.70 = $4.30, which is the price you paid. As with calls, you could certainly make a profit without the stock ever falling to $90.70 but that would require that it at least starts falling quickly so that there is still some time premium left on the option.
In a previous section, we said that different strikes behave differently and that's why some traders might choose a higher priced option when, on the surface, it doesn't seem sensible to buy anything but the cheapest one. Now that you understand breakeven points, you can gain some more insight into why that's true. If you buy the $95 call, the stock must rise to $97.90 to break even. But if you purchased the $90 call for $5.90, then the stock must only rise to $95.90 in order for you to break even. It's always a good idea to check that the break even point is in line with your outlook on the stock before buying the option. For instance, if you think the stock will rise from $93.60 to $95, then it's probably not a good idea to buy the $95 call since its breakeven point is $97.90, which is higher than your outlook on the stock.
Lower Strike Calls and Higher Strike Puts are Always More Expensive
In Figure 1, notice that the $80 strike call is more expensive than the $85 call. The lower strike calls will always be more expensive than the higher strikes regardless of which underlying stock you're looking at. Why? There are many mathematical reasons why this relationship must hold but you know already know enough to figure it out intuitively. Imagine that you walked in to buy a pizza and found the following two coupons lying on the counter. Which would you choose?
Notice that both coupons control exactly the same things and have the same expiration date. The only difference is that the coupon on the left allows you to buy the pizza for $7.99 while the one on the right gives you the right to buy it for $10.99. Obviously, you'd rather pay $7.99 so would pick up that coupon. A similar process happens in the financial markets. Traders recognize the advantage in paying fewer dollars for the shares (just as you did in deciding which coupon to pick up) and will actively compete for these coupons in the market thus driving their price higher relative to the higher strike coupons. Because these coupons allow traders to buy stock at advantageous prices, they become more valuable as the strike price is reduced. How do we know that will always be the case? Assume that, for some reason, the $90 call was cheaper than the $95 call, arbitrageurs would buy the cheap $90 call and simultaneously sell the expensive $95 call thus guaranteeing a profit. If you look at Figure 1, you'll see that the lower strike calls for a given month are always more expensive. Another way of saying the same thing is that the coupons get more valuable as the underlying stock rises. It is the relative difference between the strike price and stock price that matters. If you buy a call option, you want the stock price to rise!
For put options, higher strike puts must be more expensive with all other factors the same (the same underlying stock and time to expiration, etc.). Figure 1 verifies this relationship. If, for example, the $95 put were cheaper than the $90 put, arbitrageurs would buy the cheap $95 put and simultaneously sell the expensive $90 put thus guaranteeing a profit. These actions would continue until the $95 put is more expensive than the $90 put. As with call options, it is the relative difference between the strike price and stock price that matters. If you buy a put option, you want the stock price to fall!
Closing Options at Expiration
We said in an earlier section that you're not required to ever buy the shares of stock if you own a call option. Most traders just take their profits by selling the contracts in the open market without buying the shares. Now that we understand how to exercise a contract, as well as intrinsic values, we'll show you that there really is no difference between the two choices of either exercising or closing in the open market at expiration.
Assume you buy the eBay $90 call for $5.90 and, at expiration, the stock is trading for $100. You could exercise your call and pay $90 for the stock and immediately sell it for $100 thus capturing the $10 difference. Because you paid $5.90 for the call, your net gain is $4.10. How would you do if, instead, you just closed (sold) the option in the market? With the stock trading for $100 near expiration, the $90 call must be trading for its intrinsic value of $10. Rather than exercise the contract, you'd just sell the contract for the going price of $10. Since you paid $5.90, your net gain is $4.10. Notice that your net gain is $4.10 regardless of whether you exercise the call (buy stock and immediately sell it), or just sell the call in the open market. Of course, there is a big difference what happens after that moment in time. If you think the stock will continue higher, you may wish to exercise the call so that you can get the shares. If you close out the call in the open market, your position is closed and you will no longer participate in additional upside moves. When we say there is no difference between exercising a call verses closing it in the market at expiration, we are talking about that specific moment in time. So just because your call option is about to expire does not mean that you must purchase shares. This means you do not need the full exercise value of the contract (strike price * 100 shares) in your account at any time. All you need in your account is the amount of cash to buy the options.
For puts, the result is the same. Assume you bought the eBay $95 put in Figure 1 for $2.25. At expiration, the stock is $90. We know the $95 put must be worth the $5 intrinsic value, which is what you'd receive if you sold the put in the market. You could also buy the stock for $90 and then immediately exercise the put and receive $95, thus collecting a $5 profit. Either way, you collect $5 at expiration. Because you paid $2.25, your net gain is $5 - $2.25 = $2.75, or 122% return on your money.
Closing Options Prior to Expiration
Okay, so there's no difference to us whether we close an option at expiration when compared to exercising it and selling the stock. What about if we wish to close the option prior to expiration? Now there is a difference - and sometimes a big one. Assume you bought the May $90 call in Figure 1 at an earlier time for $3. The stock is now higher and that option is bidding $5.80. If you wish to take your profits, there is a big difference in the choice you take. Let's look at both of them.
If you sell the call option, you'll receive $5.80. After subtracting your cost, you have a net profit of $2.80. But now let's assume that you exercise the call and sell the stock. You would pay $90 for the stock and could immediately sell it for $93.60, which is a gain of $3.60 gain. After subtracting your $3 cost, you have a 60-cent profit. By selling the option in the market, we captured a $2.80 gain when compared to only a 60-cent gain by exercising the stock and selling it. Why is there a $2.20 difference between the two choices? The reason is that when you exercise a call option, you only get the difference between the stock's price and the strike price - you get only the intrinsic value - which in this case was $93.60 stock price - $90 strike = $3. When you sell a call though, you must get the intrinsic value plus you get some time value back. The May $90 call has $3.60 intrinsic value and $2.20 in time value. By selling the option in the open market, you capture that $2.20 time value, which is something you don't get by exercising. This $2.20 time value is exactly the difference between the two choices.
The important point is this: Do not exercise a call option early! You are throwing away the time value. And as if that's not bad enough, you're also holding the stock, which has a much greater downside risk than the long call. And don't forget that you paid for the stock earlier than you could have if you had waited until expiration even though you locked in your purchase price. No matter how you cut it, there's no advantage to exercising a call option early. The reason there is no difference between exercising a call at expiration when compared to selling it is because the time value is zero. There is no time remaining at expiration and the time value is therefore nothing. But prior to expiration, time value does count and there can be significant differences between the two choices.
As you become more familiar with options, you'll hear caveats to the "don't exercise early" rule such as only exercise early to capture a dividend. Exercising early may make sense but it really only offsets some small losses. Most dividends are small and usually not our concern as traders of call options (unless it is a large, surprise dividend). But for now, just understand that in the vast majority of cases, it is never to your advantage to exercise a call option early. If you wish to take profits, simply sell the call option in the open market. Now you see why the majority of contracts are just closed in the open market. Most traders never intend to buy the shares and just buy and sell the contracts by themselves.
For put options, though, there may be times when exercising early may help you. That will occur if the stock's price is significantly below the strike price. For example, assume you have the eBay $80 put and the stock tanks and is trading for $70. You see no hopes for the stock coming back above $80 by expiration of your option. Now you have a choice: You can wait until expiration and sell your shares for $80 or you can sell you shares today for $80. What do you do? You exercise early and sell your shares today. Early exercise for puts has advantages over early exercise for call. The first is that, with puts, you're receiving cash into your account, which allows you to earn interest earlier. Second, you're getting rid of stock. If you exercise a call early, you're buying stock and accepting the full downside risk.
Why do you suppose that pizza coupons have no value whereas call options do? Many are inclined to say that it's due to the prices; stocks are far more expensive than options. That's partly true but the bigger reason is due to the uncertainty of prices. You can be pretty sure that the $7.99 pizza price we saw earlier will be the same price next week. And as competitive as the pizza market is, there's even a good chance that price may fall. Because we're pretty certain about the prices we'll pay next week, next month, or even next year for pizza, there's no reason we'd want to "lock in" the price of a pizza. Consequently, pizza coupons have no value.
Options, on the other hand, do carry value since stock prices can change so unpredictably. One day the stock is up 2%, the next it could be down 10% and we're never really sure what's going to happen. Because of the uncertainty, traders are very willing to pay for the right to buy the stock - their goal is to avoid holding the stock. Stock prices that exhibit radical price changes are considered to be more volatile than one that does not. Using an everyday example, we would say that gas prices are more volatile than milk prices. We're pretty sure that a gallon of milk will cost about the same next week or next month but we're not nearly so sure about gas prices. While there are many ways to measure the volatility of a stock, that's getting a little ahead of our goal. Just understand that the more volatile the stock's price - the more uncertain we are about it's price from day to day - the more money you're going to pay for an option.
Why are options on volatile stocks more expensive? Don't we associate radical price changes with risk? And if stocks are riskier, shouldn't the options be cheaper? While it's true that risky assets are bid down as risk increases, options do not behave that way. The reason is because of the asymmetrical payoff of options compared to stock. For example, if you buy eBay at its current price of $93.60, you gain point-for-point if it rises and lose point-for-point if it falls. You participate fully to the upside - and downside - of the long stock position. You have symmetrical possible gains and losses. But now consider the $90 call. If you buy the call, you participate fully to the upside but have only a limited downside risk. In other words, your payoffs are not symmetrical as they are for the trader holding stock. With the option, you get all of the upside profits but are only exposed to a fraction of the downside risk. Assuming all option prices were the same, you'd be better off holding an option of a very risky stock since it may be worth a lot of money but can only lose what you paid for the option. Traders compete for the call options on the volatile, or risky, stocks and consequently bid their prices higher. Bear in mind that it does not follow that we should therefore only buy options on risky, or volatile, stocks. The reason is that the market places a higher price on those options and, consequently, that makes it harder to break even on the trade. We're just trying to show why riskier stocks have correspondingly higher option prices.
You now have enough option basics to take a look at some basic strategies!
As you get more familiar with options, you'll realize there are hundreds of variations of strategies. If you find one of the following that might sound appealing, you should investigate further as there are probably many variations you'll also like. The world of option strategies is very large; we're just trying to get you to see some basic uses in hopes that you will investigate further.
Let's start with the basic long call option. We've shown that call options get more valuable as the stock price rises. For any given strike or "coupon" price you hold, the higher the stock price, the more someone will be willing to buy your coupon and will, consequently, bid higher to hold it.
Let's compare two investors, A and B, who are trading 1,000 shares of eBay. Investor A uses stock while B uses options. Using Figure 1, you can see that investor A must spend $93,600 to buy the stock. Of course, putting this much money on the line means that it is possible to lose a substantial chunk if eBay should crash. Investor B can accomplish the same thing with less risk by purchasing one of the call options. Assume he buys the January $95 call for $7.40. He buys 10 contracts (1,000 shares worth) for only $7,400. No matter what happens to the price of eBay between now and January expiration, investor B has a defined maximum loss of $7,400. Notice that investor A cannot accomplish this same defined goal even if he uses stop orders. Stop orders do not prevent losses. Call options give us a very good way to create defined maximum losses, which is good money management.
Investor A is now long 1,000 shares of eBay while investor B owns 10 $95 calls. If eBay falls more than $7.40 (to $86.20 or lower) by expiration, investor A is going to wish he had purchased the calls. Investor A will continue to take losses for all stock prices below $86.20 whereas investor B will no longer take losses; his losses were defined to the first $7.40 in price movement. That was the price paid for the call option.
However, let's assume that the stock rises to, say, $110 at expiration. Investor A purchased at $93.60 and sells for $110 for a $16.40 gain, or 17.5% increase. With eBay at $110, the $95 call must be worth the intrinsic value of $15. Investor B paid $7.40 for the call and can sell it in the open market for the going price of $15, which is a $7.60 gain, or 103% increase. So the same move in the stock from $93.60 to $110 makes the stock investor up 17.5% and the option investor up 103%. Options are therefore a way to gain financial leverage, which means we can magnify our gains (and losses) in the market. Tiny moves in the stock mean large moves on a percentage basis for the option.
But let's look at that rise in price another way. Investor A gains $16.40 while investor B makes $7.60, which leaves him with $8.80 less profit. Where did the $8.80 go? In this case, there are two reasons: The first $7.40 of that $8.80 is due to the time premium paid for the $95 call. You never get your time premium back. That leaves $1.40 still missing. That missing $1.40 is exactly the amount that the call was out-of-the-money. The $95 call is $1.40 out-of-the-money with the stock at $93.60. The stock buyer pays no time premium and therefore keeps the entire $16.40 move in the stock. Investor B pays a $7.40 time premium and gives that amount up in upside profits in exchange for smaller, defined losses.
So the leverage of options does not come for free. There is a time premium that must be paid and you never get that back. This is not to say you can't recover it with movements in the underlying stock; it's just saying that when compared to the stock buyer you will always fall short in terms of the total dollars in profits, assuming you are controlling an equal number of shares.
Options Need Speed
What happens if the stock moves from its current price of $93.60 to $101 at expiration? Investor A gains $7.40 while Investor B loses the $7.40 time premium, or a 100% loss on significant movement in the stock. It is this characteristic of value versus speed that separates options from stock. Long options need the underlying stock to move quickly in order to make money. If the stock doesn't move at all or moves too slowly, then substantial losses can develop. When trading options, you need to pick the direction the stock will move and the speed at which it will get there. That is a much more difficult game than determining if the stock will rise or fall.
It is the time premium of the option that causes this "speed component" to be present. The larger the time premium, the quicker the stock needs to start moving in order to be profitable. If you're new to options, it will help to buy in-the-money options so that you reduce the amount of time premium you pay and therefore reduce the speed component that you need to assess. For example, assume Investor B had picked the January $90 call for $10.30, his breakeven point would then be $100.30 and he would have made 70 cents with the stock at $101 at expiration. Lower strike calls have lower breakeven points and are therefore less risky.
Now you know why we said earlier that options are not created equally. You can't just look down the list of option quotes and trade the cheapest one thinking that it is the best. The cheapest option needs the highest amount of speed in order to be profitable and is therefore the riskiest in the bunch. New option traders often make the mistake of thinking that all options profit in the same way. If that were true, then the cheapest option would be the best one. But experienced traders understand that they are not the same and will bid the riskier ones lower.
What if, instead, Investor B, purchased the same dollar amount of call options as the stock investor? In other words, what if Investor B buys $93,600 worth of options? In this case, Investor B will win in terms of total dollars but that is because he'd be controlling far more than 1,000 shares of stock. Using equivalent dollar amounts for your stock and option trades is reckless and not recommended by anyone (although many traders will do it). Remember that we said at the beginning that options can be used in good and bad ways; this is a very bad way! If you are comfortable buying, say, $10,000 worth of stock, you should not be a buyer of $10,000 in options.
Placing Your Order
If you wanted to buy 10 January $95 calls, you'd just need to tell your broker the following instructions: Buy to open, 10 eBay January $95 calls, symbol XBAAS, at market. Of course, you could also specify a "limit order" and say to buy them "at a limit of $7.40" or some other number. As with stock, market orders on options are guaranteed to fill - we're just not real sure at what price. It should be pretty close to the current asking price but that's not always the case. Limit orders guarantee your price but not the fill. If you place a limit order at $7.40, your order can only be filled for that price or lower. Most of the orders, contingencies, and qualifiers that you're used to using with stocks such as: market and limit order, stop, stop limits, all-or-none, not held, etc. can be used with options.
Your broker will require that you have the full purchase price in cleared funds (or margin cash available) in order to buy options. For this hypothetical order, your broker would require that you have $7.40 * 10 contracts * 100 shares per contract = $7,400 of cleared cash in your account. That's all there is to it. You'd be long 10 eBay $95 calls.
Notice that the previous instructions state "buy to open." The words "to open" are a quirk in the options market that is different from any other market. Because options are contracts, we are either entering into an agreement or exiting from one. If we just said we wanted to "buy" the option, the clearing firm has no way of knowing if we are entering into an agreement (buying to open) or exiting from one (buying to close). In order for the clearing firm to keep accurate track of how many open contracts are out there at any given time, we need to specify if we are opening or closing the position.
Let's assume that eBay rises and the price of your contract is now more valuable and trading for $9.00. If you wish to get out of the contract, you would call your broker and say, "Sell to close, 10 contracts, symbol XBAAS, at market." You would then be sold at the current price of $9 and have captured a $1.60 profit on 10 contracts, or $1,600. At this point, you're out and have no rights to buy stock - you've sold the coupon to someone else and collected a profit in between the transactions.
Let's assume that you're bearish on eBay and wish to short shares of stock. If you short stock, you're borrowing shares that you don't own with the obligation to buy them back later - hopefully at a lower price. Shorting stock has unlimited upside risk since there is no limit as to how high a stock could rise. Rather than short shares of eBay, you could instead buy a put option. Assume you buy 10 October $95 puts listed in Figure 1. You would call your broker and say, "Buy to open, 10 contracts, eBay October $95 puts, symbol XBAMS, at market." You'd probably be filled at the current asking price of $7.80, which means the trade would cost $7,800 and you'd be required to have this amount in cleared funds in your account.
You're now long an asset that behaves like a short stock position. The nice benefit about being long (owning the asset) is that the most you can lose is the amount you paid - in this case, $7,800. This limited risk benefit is far from true for someone who shorts stock. If the stock closes above $95 at expiration, the most you can lose is $7,800.
But let's assume the stock does fall as we expected. At expiration, the stock is down from $93.60 and trading for $85. The trader who shorted 1,000 shares of stock at $93.60 would make a profit of $8.60 per share, or a total of $8,600. With the stock at $85 at expiration, the $95 put would be worth the intrinsic value of $10. Since you paid $7.80, your net gain is $2.20, or $2,200 for 10 contracts. The stock fell just over 9% but your put option gained 28%, which again shows the leverage with options.
On a total dollar basis, the short stock trader makes $8,600 but the long put trader made $2,200, which is a $6,400 shortfall, or $6.40 per contract. Where did it go? Hopefully you remembered that the missing amount is exactly equal to the time premium. The $95 put cost $7.80 but had $6.40 time value ($95 strike - $93.60 stock price = $1.40 intrinsic value. If we subtract the $1.40 intrinsic value from the $7.80 cost of the option, we’re left with $6.40 time value). Remember, you never get that time value back. That's the reason there is a $6.40 shortfall in your put option profit as compared to the stock trader in this example.
This example also shows the "speed component" of the option that we spoke about earlier. If eBay falls by less than $6.40 at expiration, you'll lose money on the option – even though you were correct about the direction. For example, assume that eBay falls exactly by $6.40 to $87.20 at expiration. With the stock at $87.20, the $95 put is worth exactly the intrinsic value of $7.80. You could sell for $7.80, which is exactly the same price you paid so you just broke even on the trade. However, if the stock fell by less than this amount ($87.21 or higher) then you'd lose money on the trade.
If you wanted to close your position, you'd just call your broker and say, "Sell to close, 10 contracts, eBay $100 puts, symbol XBAMS, at market." Your contracts would be sold to someone else. You have no more rights and you're out of the contract but collected a nice profit in the process.
The long put has the right to sell shares of stock. The short put seller has the obligation to buy shares if the long put decides to exercise. Here's a nice strategy for traders looking for a way to acquire stock.
In Figure 1, ebay is trading for $93.60. Assume you want to buy 300 shares but think it will fall a
little bit in the next month. How can you use options to capitalize on this? Rather than wait for the pullback, which may not happen, you could sell a put. Let's say you decide to sell the October $90 put, which is bidding $2.15. By selling 2 contracts (200 shares worth), you will receive 2 contracts * $2.15 * 100 shares per contract = $430. This cash is yours regardless of what happens to the stock. These funds can be used immediately to either withdraw or even buy other options.
If eBay stays above $90 at expiration, the contracts expire worthless and you keep the money. But let's
assume that eBay falls to $88 at expiration. You would be assigned on the short put and would be required to buy 200 shares of stock at $90. Your account will be debited 200 * $90 = $18,000 and will be credited with 200 shares of eBay. Using short puts in this way is like getting paid to place a limit order for $90. If you thought eBay was going to fall but didn't know about options, the only thing you could do is to place a limit order to buy shares at, say $90. If eBay rises, you get nothing. But with the short put, at least you get the $430, which is something the limit order user does not receive. Both you and the limit order user are long stock at $90 but you get $425 to boot. Also notice that the initial credit from the sale of the put reduces your cost basis on the stock by the amount of the time premium, which is $2.15 in this case. The trader who uses the $90 limit order would be long shares at $90. Since you received 2.15 to sell (short) the put, your cost basis, assuming you are assigned, is $90 - $2.15 = $87.85. In this example, even though the stock is trading for $88 and you're assigned, you're still up 15 cents since your cost basis is $87.85. The initial credit from selling the puts acts as a nice downside hedge.
Notice that by selling puts, you're now acting as the insurance company. You took in the premium and are now on the hook if the long put owner "wrecks" their stock and wants you to buy it back. However, you were intending to buy stock anyway. That was a risk you were willing to assume but now the options market allows you to get immediate cash for assuming a risk you wanted to take. At the beginning of this course, we said that you will hear all different kinds of beliefs about the risks of options. We said it really depends on how they are used and this example demonstrates that. If you are willing to buy 200 shares of eBay, why should it be considered "risky" to sell puts and collect money to accept the obligation to buy 200 shares of eBay?
Short put options are a great way to acquire stock that you want to own. However, if you don't want to own the stock and are simply selling puts because you think the stock will rise, then you're speculating and are using options in a risky way. Whether options are risky or safe depends on how you use them.
Most traders new to options will always hear about the covered call since it is considered to be a basic, safe strategy. Let's take a look at how it works.
Let's assume you own 200 shares of eBay at $90 (maybe you got assigned on the short put in the earlier example - hopefully you're starting to see how you can combine option strategies to gain even more flexibility). You're willing to hold the shares and are now waiting for it to rise. Rather than wait, you can sell calls against your shares. By selling a call, you have an obligation to sell shares if the long call holder decides to exercise their right to buy. You could sell 2 contracts of the June $90 call XBAJR at $5.80, which is a total credit of 200 * $5.80 = $1,160. Again, this cash is available for your immediate use to use however you wish.
You would just call your broker and say, "Sell to open, 2 contracts, of the eBay October $90 calls, symbol XBAJR, at market." You would then be long 200 shares of stock and short 2 $90 calls.
If the stock rises above $90 at expiration, you would be required to sell for $90. If the stock stays still or falls, you still get to keep the $825, which is something that the long stock holder will never see. Remember, the cash you receive from selling an option is yours to keep regardless of what happens. Notice that this credit provides a little downside protection too. If the stock falls $5.80 below your cost basis, you're still at break even. The initial credit from the sale acts as a cushion against adverse stock price movements. If your cost basis is $87.85 on the shares (assuming you sold the put to acquire the 200 shares of eBay) and then sold the $90 calls for $5.80, your total cost basis is $87.85 - $5.80 = $82.05. If you are assigned on the short calls, you will sell your stock for $90, thus capturing a profit of $7.95, or 9.7%. Think about what happened though. You bought stock for $90 and sold it for $90 and still made a nice profit. It was the time premiums that made you profitable, which is something that stock traders will never enjoy.
Options allow traders to profit whether the stock rises, falls, or just stands still. We can control our risk, leverage our money, diversify our portfolio, and create risk profiles that cannot be done with any other asset. Options truly are a necessary asset that makes an already complex market more manageable.
These are just a small fraction of the strategies available to you. Options were created as a way to buy
and sell risk. If there is a risk you're willing to assume, you can now get paid to assume it. If there is a
risk you don't want, you can pay someone to assume it for you. The options market is the only forum that
allows us to meet speculators and trade risk. If you think you've found some interesting aspects to options
trading, we encourage you to find out more about the fascinating world of option trading and strategies
through our free online Options 201 course.