All option contracts work pretty much the same. Let’s look at a real estate option which may be more familiar than stock options.
Case Study One: You know of a real estate corner lot, near a big city that is for sale. The price has been dropping for a long time and currently valued at $10,000. Businesses in the area are not doing well and some are closing their doors. You hear a rumor that a large tech company is planning to move into this city and building a large complex near this street corner. You approach the owner of the lot and offer him $1000, non-refundable, for an option to buy the lot from him anytime in the next twelve months for $10,000. The $1000 payment would be a credit toward the purchase price if you decide to exercise your right to buy. The seller is happy to oblige because he would earn $1000 on a lot that was losing value and lock in his selling price at $10,000. The seller of the option has the obligation to sell the lot to you for $10,000 if you want to buy. You have the right, but not the obligation, to buy the lot anytime in the next twelve months.
The rumor is true. The large tech company announces a plan to build their large complex. The price of the lot begins to skyrocket in value and six months later rises to $100,000. You have two choices:
Choice 1: Exercise your right to buy the lot for $10,000, that is now worth $100,000, and sell it to another buyer for $100,000. This choice would require you to come up with an additional $9,000 cash to buy the lot. Your total investment at this point would be $10,000. This includes the $1000 you paid the original seller to buy the option. You then buy the lot for $10,000, sell it for $100,000, your profit is $90,000.
Choice 2: A new potential buyer approaches you and offers $100,000 for the lot. To make it simple, you sell your option to this potential buyer for $91,000. You are willing to take less than the full value of the lot so you don’t have to come up with additional cash to buy the lot and then re-sell. You paid the original owner $1000 for your option to buy the lot so your profit is $90,000. The new buyer now holds your option contract that allows him to buy the lot for $100,000.
This is the way a call option on stock works.
Case Study Two: You did a lot of study on the new tech company after they made their announcement to move into the city. You considered they may change their mind and not move after all. You approach the new owner of the lot and offer him $10,000, non-refundable, for the option to sell the lot back to him for $100,000 anytime in the next twelve months. The owner is more than happy to oblige because the value of the lot has been skyrocketing due to the tech company’s announcement and he feels he can make an extra $10,000. You have the right, but not the obligation, to sell the lot for $100,000 within the next twelve months. The seller of the option has the obligation to buy the lot from you for $100,000 if you want to sell.
Your guess is right. The large tech company changes its mind and announces they will not be moving into the city. The lot price starts to plummet and the value falls back to $10,000. You then exercise your right to sell the lot back to the seller for $100,000. You spent $10,000 for the option to sell for $100,000 giving you a profit of $90,000.
This is the way a put option on stock works.
Option Types:
Call Option:
- Gives the buyer of a call the right, but not the obligation, to buy the underlying stock at a fixed price (strike price)
- If a trader believes the stock price will rise in the future they can lock in a lower purchase price with a call.
- If the stock goes up the buyer makes money because they have the right to buy the stock at the lower price.
- If a trader believes the stock price will stay at the same price, or fall in the future, they can sell the call to the other trader.
- The seller of a call option has the obligation to sell the stock at the fixed price (strike price) to the other trader.
- The seller’s profit is the premium the buyer of the call pays them for assuming the risk of their obligation to sell the stock to them.
- If the stock price stays the same or goes down the seller makes money because they keep the premium the option buyer paid them.
Put Option:
- Gives the buyer of a put the right, but not the obligation, to sell the underlying stock at a fixed price.
- If a trader believes the stock will fall in the future they can lock in a higher selling price with a put.
- If the stock goes down the buyer makes money because they have the right to sell the shares at the higher price.
- If the trader believes the stock is going to stay the same or rise in the future they can sell the put to the other trader.
- The seller of a put option has the obligation to buy the stock at the strike price from the other trader.
- The seller’s profit is the premium the buyer of the put pays them for assuming the risk of their obligation to buy the stock from them.
Strike Price
- The strike price is the fixed price at which the option buyer has the right to buy or sell the underlying stock.
In the Money/Out of the Money
- A strike price on a call that is below where the stock price is currently trading is “in the money”.
- A strike price on a call that is above where the stock price is currently trading is “out of the money”.
- A strike price on a put that is above where the stock price is currently trading is “in the money”
- A strike price on a put that is below where the stock price is currently trading is “out of the money”
Premium
- The price a buyer of a call or put option will pay the seller.
- The premium is paid to an option seller for carrying the risk that comes with the obligation to sell or buy stock to or from the buyer.
- The option premium depends on the strike price, price volatility of the underlying stock, as well as the time remaining to expiration.
Option Chain
- Premiums are displayed in the option chain.
- Premiums are listed as price per share.
- Price per share needs to be multiplied by 100 to get the full premium a buyer of a standard option will pay.
- Premiums depend on underlying share price, expiration date and how far in or out of the money is the strike price.
Expiration Date
- Option contracts are wasting assets and all options expire after a certain period of time.
- The closer you get to the expiration date the less valuable the option becomes. This is called time decay.
- Once the stock option expires the right to exercise no longer exists and the stock option becomes worthless.
- The expiration month is specified for each option contract.
- Standard stock options listed in the United States expire on the third Friday of the expiration
- Weekly options expire on Friday and are of very short duration, typically 1 to 3 weeks.
Underlying Asset
- The underlying asset is the particular stock that the option seller has the obligation to sell to the buyer of a call or buy from the buyer of a put.
Exercising the Option
- If the option buyer wants to exercise their right to buy stock (call) or sell stock (put) it is called exercising the option.
- Only the buyer has the right to exercise the option.
- The vast majority of options are not exercised by buyers but instead the contracts are sold before the expiration date.
- Options are also available for other types of securities such as currencies, indices and commodities. For our purpose we will stick to stock options.
Contract Multiplier
- The contract multiplier states the quantity of the underlying stock that needs to be sold or bought in the event the option is exercised by the buyer.
- For stock options each contract typically covers 100 shares.
- A new change in options are contracts that cover only 10 shares referred to as mini contracts.
- Smaller traders can trade these options but not recommended.
The number of trades, called volume, on these contracts are typically lower than standard options and you may not be able to buy or sell mini options in a timely manner.
