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Share Options Explained
Share options or stock options are a way to leverage a large amount of shares with a small amount of money. You do this by buying options contracts, known as calls or puts, which give you the option to buy or sell a certain amount of shares at a predetermined price (known as the strike price) on or before the expiration date of the options contracts.
An options contract typically controls 100 shares of the underlying stock.
In other words, if you buy 10 call options for Apple shares, you are buying the option or right to control (or ultimately purchase) 10 x 100 = 1000 shares of Apple stock.
Since nothing in life comes for free, the major risk of options is that you can easily lose your entire investment – so you should be very aware of that up front and understand that options are extremely powerful, but extremely risky.
Why buy options instead of buying shares of stock when options are so risky? Because you can buy options with a small amount of money and stand to make a very large amount of money. This is because you are controlling a very large number of shares with this small amount of money. As with our example of Apple stock, 1000 shares at $100/share would cost 100 thousand dollars. However, with options, you could spend just a few hundred dollars and control the same amount of shares. But remember, it’s very hard to profit with options. The odds are stacked against you and options are essentially gambling; whereas buying shares is more about investing.
Exercising options – Exercising an option refers to exercising your right to buy or sell shares at the strike price; so, if you exercise your options, you are buying those shares. If you own 10 options on Apple shares and exercise them, you are choosing to buy or sell 10 x 100 = 1000 shares of Apple stock depending on the type of option you own (calls or puts – more on this below.)
The other thing you can do with options, which is a bit less risky, is that you can sell or “write” options. This is more complicated and particularly so without a full understanding of how options work, so we’ll discuss it in a future post.
Let’s look at the various characteristics and types of options.
There are two main types of options –
Call options are options to BUY shares. You would typically buy call options if you expect the underlying shares to go up in value. Call options are more commonly referred to simply as “calls.”
Put options are options to SELL shares. You would typically buy put options if you expect the underlying shares to go down in value. Put options are more commonly referred to simply as “puts.”
When you buy or sell shares of stock, all you really need to worry about is the share price. Options are quite a bit more complex. The key attributes of an option are its expiration date and strike price. Essentially it is a combination of the expiration date, strike price and underlying share price that determine the price of an option.
Let’s consider a call option for Apple shares that has the following attributes –
Strike price = $100
Expiration date = December 19, 2014
Let’s further assume that Apple’s current share price is $101
Because this is an option to buy shares at the strike price, if we were to “exercise” the option, we would be purchasing 100 shares per option contract at the strike price of $100. Because the underlying share price is currently $101 in our example, that would yield a profit of $1/share or $100 per contract. So these call options are worth at least $1 x 100 shares/contract. That means the price the option is trading at will be at least $1. $1 in this case would be considered the “intrinsic” value, and these options would be considered to be “in the money” options. In the money options means that the share price is more than the strike price and if you exercised them today, you would yield some positive amount of money.
But remember, nothing comes for free. With options, one of the key components of the option’s value is the time-value of the option. In effect, that’s the main thing you are buying with an option. You are buying time.
In our example, the options expire December 19, 2014. (The third Friday of December) That means these options will become worthless after the market closes on December 19, 2014 (unless you end “in the money” in which case your brokerage might automatically exercise the options for you, so again, be very cautious and understand your brokerage’s policies with regard to options as well as how options work.)
Let’s assume we are looking at these options on October 19, 2014, two months before they expire. Well, that’s a full two months that the underlying shares have to go up (or down) … so there’s a lot of time value there. It wouldn’t be unreasonable for a stock like Apple to go up $5 in that time-frame. So perhaps the time value is about $5. Thus these options might sell for $6 per contract (and x 100 because remember that each contract controls 100 shares.) Yes, this pricing convention is confusing, but options are quoted not in their actual price but in their price divided by 100 for simplicity (or maybe just to make you think you’re not risking quite as much as you are.)
So one of the main things to keep in mind when buying options is that the further away from expiration you are, the higher the “premium” on the option will be … and so because you are paying a premium, you will need the stock price to move considerably in order to profit. It’s not uncommon for an out-of-the-money option’s price to remain pretty consistent if a stock only moves a little bit. Also keep in mind that most options have a wide spread between the bid and ask, so since you’re buying at the ask price and selling at the bid price, you have yet another hurdle to get over before you profit.
Our illustration showed how a call option works, but what about put options?
Well, put options are sort of the opposite. A put option is an option to sell shares (in lots of 100) at the given strike price on or before the expiration date. So in this case, we’re betting the shares will go down in price.
Using Apple again as our example, let’s again assume Apple shares are trading at $101, and you are looking at a December 19 put with a strike price of $100. In this case, you need the price to go down to increase in value. Assuming again that we’re buying these about two months ahead of expiration, there is some good time value here – if you believe the shares will go down ahead of expiration, you have time for that to happen. Let’s assume that you bought these puts at $1 per contract (x 100 of course.) If you are going to hold these puts for a while, realize that you probably need them to go below $99 in order to have any real value. This is because the strike price of $100 – a trading price of $99 = $1
With put options, your initial purchase of the puts is actually just like selling the shares. When you sell the puts, it’s like buying the shares. That’s how you profit when the price goes down. It’s basically like reversing the order of time. So you need the share price to go below the strike price by at least the amount you paid.
Some important notes about options –
1. They are not nearly as liquid as trading shares, so the bid and ask price will often be considerably apart – and when you put in an order even for a small number of options, you can often “move the market” – this means that the ask price might actually change when you put in your order and become more expensive to purchase unless your order was at the ask price.
2. Make sure you understand how much time is left on an option when you purchase options. It can definitely get confusing. There are lots of different kinds of options out there now – monthly options, weekly options and long-term options. Be certain you are buying what you want to be buying.
3. We can’t emphasize enough that you stand a very good chance of losing the full value of your investment with options if the underlying share price moves in the opposite direction you are hoping for.
In a future post, we’ll aim to discuss some more advanced ways to work with options.
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Stock market basics
Stock charts explained
Stock dividends explained
Stock Split Explained
Why do shares move up and down?
How do I read a stock quote?
Understanding company financial statements
Rights issue of shares
The process of buying shares
Why buy shares
Age limit for trading shares
Tax rules on shares
Styles of trading
Buying (going long)
Shorting stock (going short)
Stop losses explained
Stock market explained
What market to buy shares
Factors that affect the stock market
When does the stock market open?
Stock market trading guide
Step by step guide to trading shares
5 golden rules when trading shares
The risk:reward ratio
Stock market games
Stock market 60
Stock market suicide
Advanced stock market trading
IPO (Initial Public Offering)
Exchange traded funds (ETF's)