Stock Options

    What are Stock Options ?

    A stock option represents a contractual agreement between two parties which gives the buyer the right to buy or sell an underlying asset at a predetermined price, on or before a predetermined date.  There are two types of stock options contracts; one is referred to as a call option while the other is referred to as a put option.  The buyer of an option is known as the “holder” while the seller is referred to as the “writer”.

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    The buyer of a call option is taking a bullish position while the buyer of a put option is taking a bearish position on the underlying asset.  The only monetary risk of buying stock options is the actual price paid for the option.

    Selling a stock option is a different story.  When you write an option, you are giving the counterparty the right to buy stock from you in the case of call options and sell stock to you in the case of a put option.  We should also differentiate between covered options and naked options.  A covered position is a hedge and is created when a trader sells an option and takes an equal position in the underlying asset.  Covered calls are created when a trader is long the stock and short the calls while a covered put is created when the trader is short the stock and short the put.  Naked positions on the other hand are created when the trader has a short option but no position in the underlying to hedge against the risk.  In theory, a short call option has infinite risk while a short put option has risk equal to the value of the stock.  If someone can make you buy a stock (“put” you into a stock) at a certain price, you can only lose in an amount equal to the value of the stock assuming it goes to 0.

    Stock option trading has become increasingly popular amongst the active trading community and traders use them to hedge their positions or even speculate.  More advanced users will trade different options strategies which allow them to take advantage of the large amount of leverage with a low amount of risk. 

    Stock Option Basics

    We are now going to cover a few key components which govern the rules around exercising a stock option. The exercise (strike) price, expiration date and option type represent these rules. In this section, we will also cover the basics in options valuations as well.

    Exercise Price (aka. Strike Price)

    Exercise price, aka. "strike price", refers to the price at which the option buyer can exercise his/her right to buy or sell the underlying security of the option contract. For example, let’s say that you purchased 10 March $60 call options on Merrill Lynch.  As the purchaser of the option, you will have the right to buy 1000 shares of MER at $60 before the expiration date. Now, you would have paid this premium to have the option to buy this stock at $60 only if you believe that it will be above that price by the expiration date of the option. 
    You can now see why stock option investing is a bit more difficult when you purely speculating on a direction.  You could be right on the direction but if your strike price is too far away and does not get hit, the option is worthless.

    Expiration Date

    Expiration date refers to the date up until which the option can be exercised. In our example above, the expiration date of the Merrill Lynch option would the third Friday in March.  Stock options expire on the third Friday of every month. 

    The value of a call option at expiration, as long as the last price is above the strike price, is the intrinsic value of the option or: (last traded price - strike price). Conversely, the value of a put option at expiration is: (strike price - last traded price).  Here is a component which is yet another reason why stock options trading can be difficult if you are purely speculating on direction.  Not only does your position have to move by a minimum amount, but it must do it in a defined amount of time. 

    Option Types

    Stock options can have exercisability options; American or European. The majority of all options traded are American style, and US equity options are all American style. The key difference between American and European options lies in the ability of the option holder to exercise the option. American style options are exercisable at any date up until options expiration while European style options are only exercisable at expiration. For this reason, American stock options command a higher premium.

    Options Valuation

    Remember, stock options are a separate entity than the underlying security that they are derived from. They have their own ticker symbol and can be bought or sold at any time. We discussed the basic components of an option; strike price and expiration date. These represent price and time and therefore we can say that the price of an option is derived by adding up the intrinsic value and time value of the option.

    Intrinsic value is basically the value of the option that is in the money (ITM). Let’s refer back to our Merrill Lynch example once again. If MER was trading at 65 when the strike price was $60, we can say that the stock option is in the money by $5. Time value is the second portion of the option and this represents the value associated to the risk that remains for the seller of the option due to the time to expiration. For example, if we buy a 3 month option and a 9 month option, the intrinsic value on both will be the same; however, the 9 month option will have a greater time value component due to the greater time risk that the option seller is taking.

    Out of the money calls (OTM) are options in which the current price of the underlying security is below the strike price. In this case, there is no intrinsic value and the option is made up of only time value. An option is said to be “at the money” (ATM) when the last traded price is the same as the strike price of the option. Again, there is no intrinsic value for an ATM option, just the time value.

    OTM puts work the opposite way; puts are considered OTM when the last traded price is higher than the strike price. Conversely, puts are considered in the money when the last traded price is lower than the strike price of the option.

    Conclusion

    We have just reviewed the very basics of stock options and options terminology. Options are great in that they allow you to control a large amount of stock with a relatively small amount of money; however, stock options trading can be quite dangerous if not utilized properly. 

     

    Tim Ord
    Ord Oracle

    Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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