An option is a contract that gives its holder the right to buy or sell an asset within a specified time frame and price. There are two fundamental types of options, Calls & Puts. A call option gives the holder the right to buy shares of a security at a set price by a set date. A put option, on the other hand, gives the holder of the contract the right to sell shares of a security at a set price by a set date.
Call Options
Call options give the option holder the right but not the obligation to buy the underlying stock at a predetermined price (known as the strike price) by a specific date, known as the option’s expiry date. They’re a type of option that increase in value when the underlying stock rises and are one of the most popular types of options.
For this right, the call option buyer would pay a “premium” which the call option seller will receive. In contrast with stocks, options have an expiry date where on that date, they may expire worthless or be exercised.
The major components of an option are
- Strike Price – The strike price is the price that you are allowed to buy the underlying stock
- Premium – The price of the option that an individual would pay
- Expiration Date – The expiry date when the option expires and is settled
Each option is known as a contract and each contract represents a claim of 100 shares of the underlying stock. Option prices are quoted in terms of per share price and not the total price that you may pay.
For example, Jim is planning to buy 1 option of American Airlines. The price is quoted at $0.85. His total premium to purchase one contract will cost $85. (100 shares x 1 contract * 0.85)
Call options may be in the money or out of the money. They’re considered in the money when the stock price is above the strike price at the expiration date. The owner of the option can exercise the option by utilizing cash to buy the stock at the strike price. If the owner of the option is not interested in exercising the option, they can sell it another buyer.
For example, Jim has 1 option of American Airlines with a strike price of $50. The stock is currently trading at $55 per share. Jim has the option to buy 100 shares of American Airlines at $50 by exercising the option and utilizing cash to purchase the shares. By exercising the option, Jim can go ahead and sell the shares at $55 each.
It’s important to factor in the premium as well. Jim would profit if the premium paid is less than the difference between the stock price and the strike price. For example, he bought the call at a price of $0.85 with a strike price of $50. The stock is currently $55. The option is $5. Jim would have made a profit of $4.15
If the price of the stock is below the strike price at the expiry date, then the option would be out of the money and expire worthless. The seller who sold the option would keep any premium that they received for the option.
Put Options
Put options are the opposite of call options. They give you the right but not the obligation to sell a stock at the strike price by the option’s expiration date. The value of put options increase as the price of the stock falls.
To purchase a put option, the buyer would pay the seller of the option a premium. At the expiry date, the option may be settled or expire worthless.
For example, Jim is looking to purchase 1 put option on American Airlines. The price of an option is currently $1.50. As each contract option represents a claim of 100 shares of the underlying stock, the total cost for Jim to buy 1 option contract of American Airlines would be $150. (100 Shares * 1 Contract * $1.50)
Put options would be considered in the money when the stock price is below the strike price at the expiration date. At that date, the owner of the put option may exercise the option or sell it at the fair market value.
Jim would profit on his American Airline put if the premium paid is lower than the difference between the strike price and the stock price. Jim purchased the put option for $1.50 with a strike price of $50. The current price of American Airlines is $45 at expiration. The option is worth $5 meaning the Jim has made a profit of $3.50. He can choose to exercise the put contract and sell his shares at $50 each when the stock price is trading at $45.
Usages of Options
Speculation
If you buy an options contract, you’re betting on the direction of the security.
This kind of bet requires sophisticated knowledge of financial markets and a high risk appetite and comfort with volatility. To become a successful options trader, you must understand and predict why a stock will go up or down and how much the price could change. You have to be mindful of macro and global fundamentals.
Buying options also allows you to use leverage. Leveraging allows you to pay only a small percentage of the share, $10 instead of $100, for example. Leveraging therefore allows you to make substantial profits with a minimum investment. If your predictions are accurate, you could double or triple your initial investment. If not, you could lose your initial investment entirely.
Options trading can be extremely risky.
Hedging
Think of it as using options as an insurance policy to protect your stocks against a downturn.
Why buy options if you’re so unsure of your stock pick? This strategy can be useful to limit losses. It’s used by large institutions who buy large blocks of options.
Even the individual investor can benefit. By using options, you would cost-effectively be able to restrict your downside while enjoying the full upside, as in the example below.
Let’s say you buy 100 shares at $30, hoping they will go up soon. To hedge, you buy a put option at $1 a share, paying a total of $31 per share. The contract guarantees a selling price of $25 over the course of next 3 months. 2 hypothetical situations could occur during this period.
The stock price goes down. You limit your losses if the stock price drops to $15. Instead of losing $15 per share, you lose $6 (($30 +$1) – $25).
The stock price goes up. You make a profit if the share climbs to $40. Your profit is reduced by $1 a share because your put option is now worthless.
How Options Work
There are several factors which help determine the price of options.
The current price of the underlying security – Being mindful of the price of the underlying investment plays an important part in determining the option price. There is a direct relationship between the current price of the security to the option premium. When the current value of the underlying security rises, call option premiums also increase. Put option premiums would decrease.
Strike Price – There are different strike prices of an option. Each strike price shows a different response to the changes in the market. Option prices are more volatile for strike prices which are near to the current price of the underlying security and vice versa.
Expiry Period – Options have a limited lifespan and expire after a certain time. The value of an option will increase with more time available before expiry date. The reason for this is because the more time available before the expiry date, the higher the chance of generating a profit.
Dividends – Believe it or not, the price of call and put options get affected by the value of dividends declared by the underlying company. To understand how, it’s important to be aware of the dividend landscape and potential risks. Before launching into a broader discussion, here is a brief review of some important terms related to dividends:
- Declaration Date: the date details of the dividend (amount and timing) are announced to the public
- Record Date: the date an investor needs to own the stock in order to receive the dividend
- Ex-Dividend Date: the date investors buying the stock will no longer receive the dividend
Both call and put options are affected by the ex-dividend date. Put options become more expensive since the price will drop by the amount of the dividend. Call options become cheaper due to the anticipated drop in the price of the stock, although for options this could start to be priced in weeks leading up to the ex-dividend.
American vs. European Options
- American Style Options – The term “American style” options has nothing to do with geographical boundaries but merely defines certain terms of the contract. Option contracts have an expiry date at which the option owner has the right to buy or sell the underlying security. With American style options, the owner of the contract has the right to exercise the options at any time prior to the expiry date. American style options offer more flexibility and a real advantage in comparison to European style options.
- European Style Options – Holders of European style option contracts do not have the same flexibility as holders of American style options. If you hold a European option, you may exercise your right to buy or sell the option only on the expiration date and not before. Due to this limitation, European options are cheaper to purchase in comparison.