by guest author Nicholas
This is the beginning of a multi-part series because options are generally thought of as complex transactions. Do you think options are risky? Options were originally created to reduce risk. I preface the next few days postings by saying, do not rush out to invest in options until you understand the risks involved.
What is an Option?
An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument. The underlying instrument that I will focus on is a stock. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised. It has an expiration date. Upon expiration, it no longer has value and no longer exists.
What does an Option Consist of?
An option is either a call or a put.
A call gives the owner the right to buy the underlying security at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a call option, the contract represents an obligation to sell the underlying stock if the option is assigned.
A put gives the owner the right to sell the underlying security at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a put option, the contract represents an obligation to buy the underlying stock if the option is assigned.
What does that Mean?
I will start today by only discussing call options from the buyers point of view. Let’s take an example. Say I want to purchase 1000 shares of XYZ stock. XYZ closed today at $26.95. I could purchase those 1000 shares, and I would pay $26,950.
Question: Why does anyone buy a stock?
Answer: Because they think it will move up.
With options, the question that I have to ask myself is when will it move?
I personally believe that XYZ stock will go up to $31.00 by the middle of December. So instead of risking my $26,950, I could buy 10 call contracts (one contract equals 100 shares of the underlying instrument) of the $30 December strike price. Each December call is currently valued at $0.65 per share. These expire on the 21st of December. So if each call is $0.65 and I want 10 contracts of 100 shares each, I will pay $0.65 x 1000 for a total of $650. So I now control, that is not to say own, 1000 shares of XYZ until the 21st of December.
Looking to the future if:
XYZ goes down to $22.00: my 10 calls will expire worthless, and I lose my $650 had I bought the options.
Had I bought the stock, it would be worth $22,000, and I would have lost $4,950.
XYZ goes up to $34.00: my 10 calls give me the right to buy those 1000 shares at $30, and I could sell them on the open market for $34. The calls are then worth at least $4 per share. So I sell them for $4 a share x 1000 shares for a total of $4,000. I subtract my $650 for a gain of $3,350 or a 515% return on my money.
Had I bought the stock, the 1000 shares would be worth $34,000 minus my initial $26,950 for a gain of $7,050 or a 26% return on my money.
XYZ stays at $26.95: my 10 calls expire worthless, and I lose my $650 had I bought the options.
Had I bought the stock, the 1000 shares would be worth $26,950, and I lose nothing other than the time value of money.
Tomorrow I will continue the discussion, but from the above example, one can see how an option will allow you control over a certain amount of shares of a stock for a specific time with a limited amount of money required, relative to buying the stock. The upside is that it is possible to execute many of these trades with the same amount of money required to purchase one stock. The downside is that the option is only valid for a specific amount of time.
Stay tuned for more. Feel free to ask questions, and I will answer them as best as possible.