An Introduction to Options

Learning to Speak Optionese: An Introduction to Options

Today We’re going to talk about what an Option is, and the two different kinds of options: Calls and Puts.

First, consider this scenario: you want to buy this really badass necklace. However, you’re not sure how much it’s worth. The vendor is trying to charge you one-thousand dollars, but you tell him that the necklace isn’t worth nearly that much. “You’re wrong,” the vendor says, “this necklace is enchanted!” The vendor claims that the necklace will give you good luck. He also says the effect will not be apparent instantly. Knowing it to be unlikely that the necklace is actually enchanted, you are skeptical and reluctant to purchase it.  Even still, there is a small chance the necklace is truly enchanted. If that were the case, the necklace would be worth far more than one-thousand dollars. It could be worth one-million! So you strike a deal with the man; for a 5% premium on the asking price (fifty dollars), he will hold the necklace for you for a year. During which time you can uncover its actual worth. If you decide you want to buy it the deal also guarantees you a buying price of one-thousand dollars, but if the necklace turns out to be a phony, as you suspect, then you don’t have to purchase it. This ‘deal’ is the equivalent of a call option contract.

So what’s the definition of an option? An option is a contract that gives the buyer the right but not the obligation to buy or sell one-hundred shares of the underlying security (stock) at a specified price known as the striking price. Each option contract expires on a certain date, and so they are what is known as a wasting asset (they lose value as time passes). In return for this privilege the buyer pays the seller a premium. The buyer is happy to have the potential of unlimited gains that a stock option warrants, and the seller is glad to have gained guaranteed income simply holding stock he already owns. The seller’s strategy is known as writing a covered call, which will be covered in the next post...

So what are the two types of options?

-A Call gives the buyer the right, but not the obligation to buy 100 shares of the underlying stock at a specified price.

-A Put gives the buyer the right, but not the obligation to sell 100 shares of the underlying stock at a specified price.

People who think the price of a stock will increase, or “bulls”, generally purchase calls, where as people who think the price will fall, or “bears”, are generally purchaser’s of puts.

Along with simple purchases, there are more intricate multi-option positions which will be covered in the future.

Side Bar:

Why Options? Some of you may be wondering, why would I buy a stock option when I could simply buy the underlying stock. Options offer a trader or investor more dynamic positions than a simple stock purchase. The investor or trader can easily protect portions of their capital or take on greater risk by properly using the built in leverage an option offers. Take for instance this example: You are bullish on stock XYZ. XYZ trades for forty-five dollars a share, and options to buy the stock at fifty-dollars in January trade for a mere fifty cents (or fifty-dollars a contract). For only $50 you control $4,500 in stock. Not too shabby. If, as you suspect, XYZ is above $50 in January, you will make money, and if XYZ goes bankrupt, has a decline in share price, or does absolutely nothing you only lose your $50. With proper money management, options can fit all risk appetites.

A Note On Purchasing Options: Option contracts cost more than they are quoted for, an option trading for  1.00 will actually cost you $100, you pay a dollar for each share you control through the option. I will talk more about how options are priced later this week.

Now, the scenario with the enchanted necklace may sound silly, but in life and in the financial markets everyone is always looking for a ‘get rich quick scheme.’ Despite the fantastic leverage options offer (usually 100 shares per contract), there is still a great amount of risk involved. I’m afraid there is no magic necklace of riches. If there were, why would someone knowingly sell it? Making money in the options market may seem easy at first, but it is a zero sum game, and it is just as easy to lose money as it is to make it. Stay the course, let’s learn to walk before we run!

Still to Come This Week:

·         The Covered Call

·         Option Pricing Basics

Until Then,

Spencer Sundahl