Investing in Options

Everyone that has considered options investing at one point of time or another has heard someone say "Options are risky! You can lose your shirt!" Is this true? Definitely. Options are highly leveraged investments and there are a few option strategies that have the potential for unlimited losses. Investors whose experience is limited to less volatile financial instruments such as mutual funds, bonds and stocks should proceed one step at a time and with plenty of education and research.

Of course, there are conservative option strategies that can be safer than buying individual stocks, but this is a lessor known characteristic of options trading. For example, the covered call option strategy is approved for investing in both Traditional IRA and Roth IRA accounts.

If you are curious about options investing, the following articles will give you an overview of the fundamentals of options.

What are Options?

Options are a privilege sold by one party to another that gives the buyer the right, but not the obligation, to buy or sell a security at an agreed-upon price on oir before a specific date. This right is granted by the person who sells the option. The person who sells the option is called the seller or writer of the option. The person who buys the option is called the option buyer. There are two types of options: Call Options and Put Options.

What is a Call Option?
A call option is the right to buy a security, usually a stock at a certain price within a specific period of time. Calls are very similar to having a long position on a stock. The buyer of a call option has purchased the right to buy 100 shares of an underlying stock at the stated price. The person who sells the option agrees to sell 100 shares of the underlying stock at the stated price. For example: the buyer of one XYZ June 50 call option has the right to purchase 100 shares of XYZ at $50 up until the June expiration date. The buyer of the call is expecting the price of XYZ to be above $50 at the June expiration date. The seller of the call is either expecting the price of XYZ to be below $50 at the June expiration or is happy selling the stock at a price of $50 (the seller might have bought the stock at $40).

What is a Put Option?
A put option is the opposite of a call option. It gives the holder the right to sell a security, usually a stock, at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. The buyer of a put option has purchased the right to sell 100 shares of an underlying stock at the stated exercise price. The person who sells the option agrees to buy 100 shares of the underlying stock at the stated exercise price. For example: the buyer of one ABC July 30 put option has the right to sell 100 shares of ABC at $30 up until the July expiration date. The buyer of the put is expecting the price of ABC to fall below $30 before the July expiration date. The seller of the put is either expecting the price of ABC to be above $30 at the July expiration or is happy buying the stock at a price of $30.

What is a Strike Price?
The strike price, sometimes called the exercise price, of an option is the specified share price at which the shares of stock can be bought by the buyer of a call option, or sold by the buyer of a put option. Strike prices are standardized and are usually multiples of $2.50 or $5.00. For example, a stock that is trading at a price of $24.50/share will likely have options with the strike price of $20/share, $22.50/share $25.00/share and $27.50/share. It should be noted that an option gives the holder the right to do something, the holder is not required to exercise if he or she does not want to or if the terms are not favorable.

What is Option Expiration?
All options expire on a certain date, called the "expiration date". For stock options the expiration date can be up to nine months from the date the options are first listed for trading. Longer-term option contracts called LEAPS can have expiration dates up to three years from the listing date.

Advantages and Disadvantages

We've already mentioned that some option strategies can be risky. But, if used in the right manner options can be a regular source of income or provide a helpful hedge to protect yourself from corrections and pullback's in a stock you already own, reducing your risk. Here is a summary of some of the advantages and disadvantages to owning options.

Advantages of Options
  1. Options allows you to drastically increase your leverage in a stock. This is a powerful feature for investors who follow speculative strategies.
  2. An option that controls 100 shares will cost much less than actually buying the 100 shares.
  3. Options can be a useful tool in hedging against declines in existing positions.

Disadvantages of Options
  1. Using options to speculate requires a close watch on open positions and a higher tolerance for risk than investing in stocks.
  2. Options require more than just a basic knowledge of the stock market.
  3. There is the potential to lose a lot of money if various positions are taken such as the uncovered, or naked, "writing of options".

Option Example

Now that you know the basic lingo of options, here is an example using Microsoft (MSFT) of how they work:

Let's say that the stock price of MSFT is $67.

1 call option contract with 2 months until expiration and a strike price of $70 will cost: $3.15 x 100 (for the underlying shares) = $315 for 1 contract.

A stock option contract is the option to buy 100 shares so you must multiply the contract by 100 to get the total price. The strike price of $70 means that the MSFT stock price must rise above $70 before the option is worth anything. Furthermore because the contract is $3.15 per share, the break-even price would be $73.15.

Note: Keep in mind that the stock price is $67, less than the $70 strike price so we actually just paid $315 for an option that is theoretically worthless. (But you might not lose the entire $315 because you are allowed to trade the options contract like a stock as long as it hasn't expired.)

Three weeks later the MSFT stock price is $78. Our options contract has increased along with the stock price and is now worth $8.25 x 100 = $825

We more than doubled our money in just three weeks! If you wanted, you could sell your options (called "closing your position") at this time and take your profits. That is, unless you think the stock price will continue to rise... say we let it ride.

Two months after we bought the option the MSFT stock price has tanked, it is now $62. Because this is less than our $70 strike price, the option contract is worthless. We are now down the original investment of $315.

To recap, here is what happened to our option investment:

Date Stock Price Option Price Paper Gain/Loss
May 1st $67 $3.15 -$315
May 21st $78 $8.25 $825
July 1st $62 $0 -$315

Notice that on May 1st and July 1st the stock price is less than the strike price of $70 so we would lose our original investment of $315.

The price swing for the length of this contract from high to low was $1240, almost three times our original investment. This is why options are considered very risky.

Hedging
Options can also be used in a way to reduce risk. Say you owned 100 shares of Microsoft and wanted to "lock-in" at the price the stock was trading. You might want to lock-in to control your risk if you believed the markets might go down substantially in the near future. In this case, buying 1 put option would protect you. If the stock price does go down you won't lose (much) money because the loss from owning the stock will be offset by the gains on your put option. Used in this way options can be actually lower your risk and act as insurance, a practice known as "hedging".

Understanding Expiration

A stock option typically has a life of 1 to 9 months before it expires. The date that the option expires is called its "expiration date". The exception to this time frame is LEAPS which have longer terms before they expire. The expiration date is the last day an option exists. For listed stock options, this is the Saturday following the third Friday of the expiration month. Although options expire on a Saturday, the options market is closed on Saturday making deadline for investors to buy or sell options one day earlier on Friday.

Expiration and In-the-Money Options
If an option is in-the-money at expiration, it will almost always be exercised. For example: If an investor owns the XYZ May 20 call and the price of XYZ stock is at $22.50/share on expiration, the call will have a value near $250. The investor can either sell the option before expiration or exercise the option. If the investor decides to exercise the option, $2,000 will be taken from the investors account and be replaced with 100 shares of XYZ stock. By exercising the call, the investor actually buys the stock at the option's strike price (in this case $20/share).

Expiration and Out-of-the-Money Options
If an option is out-of-the-money at expiration, it expires with no value. For example: Let's assume an investor owns 100 shares of ABC Stock and sells the July 30 call at a price of 2.00 using the covered call strategy. If the price of ABC Stock is below $30 on expiration day, the July 30 call expires worthless and the investor who sold the call keeps the 2.00/share or $200. Conversely, the investor who bought the ABC July call loses the $200.

Automatic Exercise at Expiration
The rules and procedures regarding option expiration vary from exchanges and brokerage firms, but most brokerage firms will automatically exercise options for their clients if the options have significant value. It is always best, however, for the option investor to give specific instructions to their broker regarding each option that is in-the-money on expiration day. Brokerage firms usually charge a fee somewhere around $20 to exercise an option.

Two Common Types of Expiration
There are two common types of option expiration dates - American and European. An American Style option is an option which the buyer or holder of the option may exercise at any time up to and including the option's expiration date. An European Style option can only be exercised by its buyer or holder on the options expiration date. All equity (stock) options in the United States (and most in Europe as well) are American style options and can be exercised at any time before expiration. In the United States, the only broad based index that has American style options is the S&P 100 Index. Other indices such as the Dow Jones Industrial Average, S&P 500 Index, Nasdaq 100 Index, NYSE Composite Index and the Russell 2000 Index all have European style options.

Why does the expiration style matter?
In most cases it doesn't. The early exercise feature of American options has almost no advantage at all because the market value of an option will always exceed its intrinsic value. Because of this, the buyer or holder of the option can sell the option and receive a higher price than if he or she exercised it. In the United States, more than 80% of all purchased options are sold back instead of being exercised.

From the Buyer's Perspective
If the buyer plans to sell back the option it doesn't matter if the option is American or European because with both styles he or she can sell the option at any time before expiration. Only if the investor plans to exercise the option and take ownership of the number of shares the option represents does the expiration style matter. With an American option, the investor can exercise the option at any point, while with an European option the investor can only take ownership on expiration day.

From the Writer's Perspective
Since the market value of an option is always more than its intrinsic value, the writer (seller) of an option does not expect it to be exercised until all the time premium (or value of time) has eroded on expiration day. If the writer wants to close out the position before expiration day, he or she could purchase back the option at the current market price.

What about deep In-the-Money Options?
On occasion buyers do exercise American options before the expiration day. In most cases the option is deep in the money and is close to expiration. Because the option is deep in the money its value will only change a small percentage with the day to day fluctuations of the stock or index price. In addition there is not much time premium left in the option because it is close to expiration. In these instances the market price of the option is extremely close to its intrinsic value and buyers will decide to exercise early. Of course, we can't forget about human error or indifference. If a buyer is mistaken about an options expiration date, he or she may exercise early. Also an investor could be going on vacation the following week and may decide to exercise the option early despite losing a little value. In these two occasions though it would more prudent for the investors to wait until the expiration day.

Option FAQs

If you purchased an option, how do you close the position?
If you purchased an option you have two different methods of closing the position. First, at any point up until the expiration date you can sell back the option that you purchased to close the position. Second, you can exercise the option. When you exercise a call option you actually buy shares of stock at the strike price of the option. When you exercise a put option you sell shares of stock at the strike price. Many investors prefer to sell back their options right before expiration instead of exchanging shares of stock.

How do you close an option position that you sold?
If you sold an option to open a position, you can buy back the option to close it. You can also wait until option expiration with the hopes that the option you sold will expire worthless. If the option you sold does expires worthless, you get to keep the price you received for the option and you have no further obligation. If at expiration there is still value in the option you sold, your option will get exercised and you will have to exchange the stock at the designated strike price.

Why trade options?
Much like stocks, options can be used to take a position on the market in an effort to capitalize on an upward or downward market move. Options allow you to leverage your investment more than other investment tools. A small investment in options gives you as much potential for profit as a much larger investment in the underlying asset itself. Options give you easier directional flexibility with less capital required. Option trades can also be constructed to give you a much higher probability of profit than just buying or selling the underlying stock.

Long-Term Options (LEAPs)

If you are considering entering the options arena but would prefer longer term investments you should take a look at LEAPS. Options are a great way to increase your leverage in an equity, but determining what direction a stock will go over a couple months is not always an easy task. It is much easier to predict where a stock will go over the next couple years.

LEAPS are short for "Long-term Equity AnticiPation Securities", they are virtually identical to regular options, providing the same opportunities to control and manage risk, or even speculate, but for much longer periods of time. LEAPS are either put or call options on selected underlying stocks that have expiration dates of up to three years. LEAPS work almost exactly the same as other exchange-listed stock options, and they are American style, which means they can be exercised on any business day prior to expiration.

LEAPS in stocks generally have 3 years (36 months) to expiration and are introduced every January. (Regular options usually last 1-6 months). The strike price for LEAPS are set at approximately 25% above or below the underlying stock's price at the time of options' listing.

LEAPS can also be purchased on underlying indices such as the S&P 500.