Options—Where Do I Begin? Part 2

Editors note: Sean Knudson, a Senior at Carthage College is an intern at The Options Institute at CBOE. He wrote an article on June 26th Options – Where Do I Begin? with his thoughts on where a new investor to options might understand and learn more about them. Here is part 2 of Sean’s article.

So have you opened an account yet? If you haven’t that’s OK. Continuing education in options is always useful.

As a quick review let’s talk about what an option is and then get into ways we can use options to participate in the market.

There are two types of options. The first is a call. A call option gives the holder (buyer) the right but not obligation to buy the underlying stock or index at the chosen strike price on or before the expiration date. A put option gives the holder the right but not obligation to sell the underlying on or before the expiration date. Conversely, the seller of a call is obligated to sell the underlying stock, and the seller of a put is obligated to buy the underlying stock. Typically options control 100 shares of stock.

 

Buy a call—Right to buy

Buy a put—Right to sell

Sell a call—Obligation to sell

Sell a put—Obligation to buy

As we get ready to discuss a few strategies, let’s lay out a few other basic concepts. First, an option is a contract that can be compared to insurance. For instance if you own 100 shares of XYZ stock at $57 and you are worried about a downside move below $55, you could buy a 55 strike put knowing that you will be able to sell your shares at $55 even if the stock falls all the way to $0. But how is a call like insurance? You wouldn’t go and get health insurance because you knew you were going to get better, would you? Well, a call option insures cash. You pay a premium for the call, but that doesn’t require you to purchase 100 shares of stock which will invariably be far more expensive, and could potentially be more risky than owning the stock.

Let’s suppose that you are bullish on XYZ stock but are worried about outside factors such as interest rates, Europe, the dollar etc. Buying a call option will allow you to participate in the market without having to buy 100 shares of stock. But it limits your downside to the amount you paid for the call. Let’s take a look at an order for an option:

 

Buy to Open 1 XYZ Aug 35 Call at the Market

Huh? It may sound confusing at first but it’s all quite logical when broken down.

Buy to Open: First we know we’re purchasing the option; it says “Buy”. Basically, we want the rights that come with it. The second part is the “to Open” part. We are creating a new position. Options do not exist until a buyer and a seller come together. A share of stock is always in existence and simply exchanges hands. An option is opened or closed, coming into and going out of existence.

1: This is the number of option contracts bought or sold.  Each contract represents 100 shares.

XYZ: Represents the underlying stock or index.

Aug: August is the expiration month. Expiration is the Saturday following the 3rd Friday of the month with Friday being the last trading day. The reason for this is that the 3rd Friday is the least likely to be a market holiday.

35: Strike Price or exercise price. In this example, this is the price at which we have the right to buy the stock, no matter how high it goes. Even if it doubles and goes to $70 we have the right to purchase the shares at $35.

Call: Are we buying a call or a put? In this case a call, the right to purchase the shares.

At the Market: This means to purchase it at the quoted price. Options, like stock, are part of a two-sided market; the bid price—the price at which people are willing to pay for the option—and the offer (ask) price—the price at which people are willing to sell. At-the-market means to buy the option now at the best available price.

Continuing with our example, let’s assume the stock is trading at $34.75 and the 35 strike call option quoted price is $1.40 bid, offered at $1.50. This means we can sell the option at $1.40 because that is the price someone (market maker, trader, investor) is willing to pay, and we can buy the option at $1.50 because that is the price where someone is willing to sell. Because we want to own the option and have sent in a Market Order, we will buy at $1.50. $1.50? That seems pretty cheap doesn’t it? Options are quoted on a per share basis. So, because our stock option controls 100 shares (at $35 per share) the value is $1.50 X 100 = $150. So, you will pay a total of $150 for the option.

How would our scenario play out? It’s a good idea to see how we would have done using charts and graphs.

 

XYZ Stock Price at Expiration

Call Value

Cost of your option

(Premium)

Profit/Loss

25

0

(1.50)

(1.50)

30

0

(1.50)

(1.50)

35

0

(1.50)

(1.50)

36.50

1.50

(1.50)

0

40

5

(1.50)

3.50

45

10

(1.50)

8.50

 

Graphically it looks like this:

 

Remember, we said our share price was $34.75 and we bought the Aug 35 call for $1.50. Time will pass to expiration (a very important part of an option, to be discussed in another blog), and the stock rises to $40 per share. How did we do? Well, the stock is now at $40, we have the right to buy at $35, and we paid $1.50.

Profit = 40 – 35 – 1.50 = $3.50

Remember again, that is per share so our dollar profit is $350. Good trade!

If the stock does not increase a great deal or “goes sideways” as traders say, then perhaps you might not want to keep the option. You may sell the option at any time before expiration. In some cases that may be better for you because if you wait until expiration the option might expire worthless. If you sell early, you might incur a loss, but getting back some of the premium you paid is better than not getting back any at all.

Many people associate stock prices with up as being good and down as being bad, but a put strategy (our example is a call strategy) might fit your market outlook if you were bearish.

Options give you the ability to participate in the market without having to lay out a significant amount of capital. In our example the stock price was $34.75, which would have cost us a total of $3,475 excluding commissions! But, because we’re option traders, we only spent $150 on the call and if our outlook of XYZ is exactly correct, with the stock closing at $40 at expiration we’re still able to take in a maximum profit of $350. That’s a 233% return! It’s not always that easy.

There are other things to consider such as volatility and time decay. But for now todays example will be enough to think about before we conquer more complex strategies and the Greeks.

Sean Knudson