Stock options trading
What is a stock option
A stock option is a contract between two parties that gives the buyer (option holder) the right (but not the obligation) to buy or sell the underlying asset (in this case shares of a specific company) from the seller (known as option writer) at a given price and within a defined timeframe (at or before the expiration date, depending on the option style).
Stock options, just as all other types of options are also known as “derivatives”, as their values derive from the value of the underlying asset. The price at which the stock option is bought or sold when exercised, is known as the strike price. Each stock option contract refers to 100 shares.
If the above definition still leaves you a bit confused as to what exactly an option is, let’s go through the following everyday life situation which should clarify this concept.
Everyday life option example
Let’s say that you find the car that you had always dreamed of but you do not have enough cash to buy it. You desperately want the car and would be able to save enough cash to purchase it in 5 months. As such, you negotiate a deal with the car owner that gives you the option of buying the car 5 months from now at a price of $30k. However, the car owner asks $1k for such option. Now let’s take a look at the two scenarios below:
1. During the test drive you notice that car is a special edition of your dream car giving the car a much higher value than the $30k you agreed to pay for to purchase it. Let’s say the market value for such car is now of $80k. The owner was not aware of this but after 5 months he is obliged to sell the car to you for the agreed price. You decide to exercise the option and made a potential profit of $49k ($80k – $30k – $1k).
2. During the test drive you notice that 80% of the car interior is not original and that the motor is not in pristine conditions. Although it is the car of your dreams, it is surely not worth $30k, any longer, but closer to $15k. Luckily you bought an option and since you are not obliged to purchase the car, you decide not to exercise the option and simply end up losing the $1k price of the option.
Why are stock options used
Stock options are widely used by investors because of their versatility. They enable investors to change their position according to how the market evolves. Options can be used either to protect your position in a stock (to hedge the risk of your investment) or for highly speculative activity (if you are “betting” on the movement of the underlying stock). The speculative side of options attracts a lot of investors who have a high risk tolerance as big money can be made. But recall that just as big money can be made, big money can be lost so unless you know exactly how option trading works and feel comfortable with it, avoid this type of speculative approach to option trading.
Types of stock options
Two types of stock options exists: call options and put options. Call options give the buyer the right to buy the underlying stock (as an option holder you want the share price to increase above the strike price) whereas put options give the buyer the right to sell the underlying stock (you want the share price to drop below the strike price).
Stock option styles: American options or European options
There are two stock option styles, American style options and European style options. When it comes to exercising a stock option, American style options can be exercised at anytime before the expiration date, whereas European style options can only be exercised at the expiration date.
Stock option expiration date
All stock options have an expiration date. Once expired, the stock option no longer holds any value as the option holder no longer has the possibility to exercise the right to buy or sell the underlying asset. American options expire on the third Friday of the Expiration month of the option. Further information on stock option expiration.
When are stock options in-the-money
A call option is said to be in-the-money if the strike price is below the current share price. A put option is just the opposite, so it is in-the-money when the strike price is above the current share price.
Stock option premium
The overall cost of a stock option is known as the premium. Such premium varies based on several factors such as the underlying asset of the option, its volatility, share price, strike price and the remaining time until expiration.
Stock option example
Now that we have reviewed the terms associated with stock options and how they work, let’s go through a theoretical example to make sure you have a complete understanding of how stock options function. The example refers to a call option.
Let’s say that the on September 1st the share price of Company A is trading at $30 and that an October 32 (this is the strike price) call option costs a premium of $2.40. Since a stock option contract refers to 100 shares, the price you pay for such contract would be $240 (the premium cost multiplied by 100). To keep it simple, in the following example we will not consider any commissions associated with the purchase of the option contract.
Such call option would be in-the-money only if the share price goes above the $32 (which is the strike price), but since we paid a premium of $2.40 for the contract, the actual break-even point would be $34.40. And don’t forget that this has to occur within the expiration date, which is the last Friday of October.
Let’s say that on September 20th, Company A’s share price is at $36. Such increase in share price would cause the value of the call option to increase as well. The option premium is now $5.60 so by selling the option you would make a profit of $560 – $240 = $320
Let’s say that you decide not to close your position and hold on to contract because you think that the share price will continue to rise. By the expiration date unfortunately this did not happen and it actually dropped down to $28. Since it is below the strike price, the option is worthless and you decide not to exercise the option.
Stock option risk
Due to the high level of risk associated with options, if you are new to the world of investing and are not yet quite sure what you are doing, probably starting with options is not the best idea. This being said I don’t want to scare you but make sure to do your homework first, understand how options work and then evaluate if they match your investment style, risk tolerance and overall investment goal. For example, if you are a risk averse investor then obviously you wouldn’t use options to speculate but perhaps you might use them to protect your investment.