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The Flexible Nature of Options: Risks for All Levels

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Michael C. Thomsett explains the basics of options trading, and why it might be a good addition to your investment plans.

Are you investing in companies or in the prices of their stock? A lot of emphasis is placed on the difference between “value” and “growth,” but perhaps a more important distinction should be made between what you invest in. If you follow the fundamentals, you are probably investing in the company; if you are a technician, your interest is in the stock and its price movement.

In either case, buying and selling stock are not the only alternatives you have. In fact, the volatility of the market, by itself, makes the case that just using a buy-and-hold strategy is very high risk when markets are volatile. All you need to do is to compare prices of some of the best-known companies between the end of 2007 and 2008 to see what a disastrous market that 12-month period was. This includes 28 out of 30 stocks on the Dow Jones Industrial Average, which all lost value. 1

When you buy shares of stock, you enter into a rigid contract. You pay money for shares, and those shares either increase or decrease in value. You are entitled to dividends if the company has declared and paid them. And if you own common stock, you have the right to vote on corporate matters put forth by the board of directors. The stock remains in existence for as long as you want to continue owning shares, and you have the right to sell those shares whenever you wish.

With options, the contract is quite different. An option controls 100 shares of stock but costs much less. However, holding an option grants no voting rights and no dividends (unless you also own the stock). You can close an option position at any time you want on listed options on stock. But perhaps the most important distinction between stock and options is that options have only a finite life. They expire at a specified date in the future. After expiration, the option is worthless. So it has to be closed or exercised before expiration to avoid losing all its value. You exercise a put by selling 100 shares at the fixed strike price, and you exercise a call by buying 100 shares at the fixed strike price.

Options, in general, contain specific terms defining their value and status. These terms include the type of option (put or call), the underlying security, the strike price, and expiration date. Every option’s terms are distinct; listed option terms cannot be changed or exchanged other than by closing one option and replacing it with another.

Terms of Options

The terms of each option contract define it and set value (known as premium) for each and every option contract. These terms are described next.

Types of Options

There are two kinds of options: puts and calls. A put grants its owner the right, but not the obligation, to sell 100 shares of a specific underlying security, at a fixed strike price, and before the specified expiration date. A seller of a put may be obligated to buy 100 shares at the fixed strike price, which occurs when the market value of stock is lower than the put’s strike price.

A call is the opposite. If you buy a call, you have the right, but not the obligation, to buy 100 shares of a specific underlying security, at a fixed strike price, and before the specified expiration date. A seller of a call may be obligated to sell 100 shares at the fixed strike price, which occurs when the market value of stock is higher than the call’s strike price.

The rights and obligations of option buyers and sellers are summarized in Figure 1.1.

Figure 1.1

Figure 1.1 Option rights and obligations

Put values rise if the underlying security’s share price falls. This occurs because the fixed strike price does not change; so the lower the current price of the stock, the more valuable the right to sell 100 shares at the higher strike price. For a call, the value rises when the underlying security price increases; so the higher the current price of the stock, the more valuable the right to buy 100 shares at the lower strike price.

For example, if you buy a put with a strike price of 35 and the stock’s market value falls to $28 per share, you gain a 7-point advantage. You can sell 100 shares of stock at the strike price of $35, or $700 higher than the current market value of the stock. If you buy a call with a strike price of $40 and the stock’s market value rises to $44 per share, your call grants you the right to buy 100 shares at the strike price of $40, or $400 below current market value.

These basic attributes of options form the rationale for all strategies, whether they involve one or more option positions, short or long, and combinations of various kinds (options hedged against stock positions, combinations of call with call, call with put, or put with put in a variety of long or short positions and employing one or many different strike prices.) The strategic possibilities are endless and provide hedging and insurance for many positions and in many different kinds of markets.

Underlying Security

The underlying security may be 100 shares of stock, an index, or a futures position. This book limits examples to options on stock, which are the most popular in the options market and also the most likely kind of underlying security most people will use for option trading. The underlying cannot be changed. Once you open a long or short option position, it is tied to the underlying and will gain or lose value based on the direction the stock moves.

The underlying may have a fairly narrow trading range, or it may be quite volatile. The degree of price volatility in the underlying (market risk) also affects option premium values. The greater the volatility, the greater the value of the option. This volatility premium, also called extrinsic value, will change as expiration date approaches; but for longer-term options, the volatility of the underlying is a significant portion of total premium value. So the attributes of the underlying are essential for judging the value of options. It is a mistake to determine which options to buy or sell based solely on their current value; the quality of a company on a fundamental basis and the price volatility of its stock (or its technical risk attributes) have to be compared and judged as well to make an informed trade decision.

Strike Price

Strike price is the fixed price at which an option can be exercised. The strike price determines total option value. The proximity between strike and the current value of each share of stock determines whether premium value is growing or shrinking. When a put’s strike is higher than the current market value of the underlying stock, it is in the money; and when a call’s strike is lower than the current market value of the underlying stock, it is also in the money. If the stock’s price moves above the put’s strike or below the call’s strike, the option is out of the money. If stock share price and the option’s strike price are exactly the same, the option is at the money.

These relationships between strike of the option and current value of the underlying security are summarized in Figure 1.2.

Figure 1.2

Figure 1.2 Option status

Expiration Date

An option’s expiration date is fixed and cannot be changed. It occurs after the third Friday of the expiration month. Standard listed options expire up to eight months out, and the longer-terms option (LEAPS, or Long-term Equity Anticipation Securities) expire up to 30 months away, always in January.

The time to expiration determines how options are valued. The longer the time, the greater the portion of an option’s premium known as time value. It may be quite high when options have many months to go before they expire, but as expiration nears, the decline in time value accelerates. By expiration day, time value falls to zero.

For option buyers, time is a problem. If you buy an option with a long time until expiration date, you will have to pay for that time in higher premium; and if expiration will occur in the near future, premium is lower, but the rapid decline in time value makes it difficult to create a profit. Three-quarters of all options expire worthless, making the point that it is very difficult to beat the odds simply by speculating in long puts or calls.

In comparison, option sellers (those who short option contracts) have an advantage in the nature of time value. Because it declines as expiration approaches, short positions are more likely to be profitable. Short sellers go through a process of sell-hold-buy rather than the traditional long position, which involves the process of buy-hold-sell. So the more decline in an option’s premium, the more profitable the short position. Expiration is a benefit to option sellers and a problem for option buyers.

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