Stock Options Basics, Part 1
April 6, 2009 – 6:12 amI’m on a kick these days that has me covering some investment basics. Perhaps a discussion on options is a bit past “basic”, but I believe every investor should know what types of investment vehicles exist regardless if they use them or not.
Also please note that I am not recommending the use of options. Although I’ve bought and sold options in the past (>5 years ago), I do not currently have any options position and I’m not looking to take on any new positions going forward.
Types of Options
There are two main types of options: “calls” and “puts”. Both represent financial contracts between two parties. In the case of a call, the buyer of the call has the right, but not the obligation, to purchase a particular financial instrument or commodity from the seller at a certain time at a certain price. The seller is obligated to sell the financial instrument or commodity should the buyer decide to make the purchase. The buyer pays a premium to have this options.
So, options essentially represent the “option” to buy or sell a security at a specific price on a specific day. There are American and European-style options. American style options allow the options to be exercised at any point before the expiration date. European style options can only be exercised on the expiration date. Note that this terminology represents the “style” of option, and does not necessarily refer to all options on an American options exchange or on a European options exchange.
Call and put options both represent 100 shares of a stock, and the quoted price of the options are per share. So, for example, the January 09 INTC (Intel Corp) Call Option at $15 costs .74 (i.e $74 per option + any broker transaction fees).
Terminology
In the example above the “expiration date” of the option is the third Friday in January, 2009. This represents the last day the contract is in force. At the end of that day if you haven’t sold the contract it will typically be automatically cleared and converted to its cash value (if any).
The “strike price” is the price that is agreed to in the options contract. In the example above the strike price is $15/share.
Call options are said to be “in the money” if the price of the underlying security is above the strike price. So for the Jan 09 INTC 15 option it would be in the money if the price of INTC was above $15. Puts are “in the money” if the stock price is below the strike price of the option.
Call Example
Using the example information above, I could buy the Intel call option above for $74 + broker fees (which typically a bit more expensive than buying and selling shares of the stock itself). Options typically expire on the third Friday of the month (or on Thursday if the Friday is a holiday and the markets are closed). For that $74 I have the right, but not the obligation to take delivery of 100 shares of Intel on or before the third Friday in January, 2009. If I chose to take delivery I would have to pay $15 times 100 shares or $1500. If all goes well and the price of Intel goes above $15/share, I still only have to pay $15. If the price goes below $15/share the option will expire worthless because no one would pay $15/share for a stock that could be purchased on the open market for less than $15.
Put Example
Put options give the buyer the right to sell (rather than buy) a financial instrument on a certain date at a certain price. The buyer of a put is assuming that the price will fall, and therefore be able to buy shares on the open market at one price and sell them to someone else (the seller of the put) at a higher price.
Going back to the Intel example, at the time of this writing a Jan 09 INTC put with a strike price of $15.00 is selling for 0.60. So, for $60 I could buy one option that give me the right to sell 100 shares of INTC at a price of $15 by the third friday in January ‘09. If the share price falls to $12 by the expiration date then I would get the difference in the share and stock price (15-12 = $3) times 100 shares = $300 minus broker fees. If the share price goes up then the option would expire worthless because I wouldn’t want to sell someone stock at $15 when it’s available on the market at say $17/share. I’d lose $2/share in that scenario.
In the next post in this series I’ll cover the main drivers in how options are priced.
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