Stock Options — The Basics

Nowhere does the testosterone flow faster than within the pits of the CBOE and other options exchanges.  Options trading has long been a male purview, and guys seeking outsized returns often display more balls when brains.  However, shrewd investors understand that stock options can be deployed as defensive instruments in addition to when you seek to hit the proverbial ball out of the park.  The largest obstacle to most individual investors when it comes to including options within their overall investing strategy is that most haven’t a clue as to how options work.  In actuality, options are quite simple to figure out if you are able to do simple addition, subtraction and multiplication.

A call option gives you the right — but not the obligation — to purchase a given stock, at a given price, and it is valid for a given duration.  These are the three key components of a call option — the underlying stock, the “strike price” and the expiration date.  Let’s take for example the stock of CitiGroup (ticker symbol C)which is currently trading at approximately $3.75 per share.  There are a wide range of call options which are based upon the price of the underlying stock of C.  These call options have varying strike prices and expiration dates.  For example, there are strike prices at $2, $3, $4, $5, $7.50, $10.00, etc etc.  The strike price is the price at which you have the right to buy shares of C.

Let’s ponder the $5 strike price.  Why would you want the right to buy shares of C at $5 when they are only trading at $3.75?  This takes us to the expiration date.  The longer your option is valid, then the more chances the stock will gain to exceed the strike price.  For example, think about an expiration date of January 2025.  What would be the value of the right to buy C shares at $5 valid until 2025?  That is quite a long time, who knows how high C could go between now and then.  Conversely, let’s say the expiration date was tomorrow.  That is obviously a short amount of time, and seeing C moves a few cents a day these days, the odds of it jumping above $5 in one day are quite slim.

Therefore, an option has greater value with a lower strike price and longer duration.  Take for example the C options with a $4 strike price and expiration of January 2011.  These have a decent amount of time left — several months — and the $4 strike price is only 25 cents above where C is trading today.  If you think, for whatever reason, that C is going to increase substantially between now and the end of the year, then you have two ways to play it.  The first is to just buy shares of C for $3.75 a share.  The second would be to buy C call options.

Each “contract” of a stock option gives you the right to buy 100 shares.  So, one contract of C stock options gives you the right to buy 100 shares of C at the given strike price of the contract.  Think about the above example of an options contract for C with a strike price of $4 and an expiration date of January 2011.  Options contracts are quoted with their own price, and using the above example contract assume it is trading for 25 cents.  This mean each contract cost you $25, and it gives you the right to buy 100 shares of C at $4 valid through Jan, 2011.

So you have decided to play your thesis on C via this options contract instead of buying the shares.  You buy 100 contracts of this option which cost you $2500.  This gives you the right to buy 10,000 shares of C at $4 valid through Jan, 2011 — but you are not obligated to make this purchase.  If C closes below $4 at the expiration date, then your option expires worthless and you lose the entirety of your investment.  Obviously, the right to buy C at $4 is only worth something if the shares exceed that amount.  This is what makes options very risky.  However, with risk there is reward.

Let’s assume your thesis was correct and C shot up to $7 by January 2011.  You own the right to buy 10,000 shares at $4.  This means they are $3 “in the money”.   Upon expiration, this contract will be trading for $3 per contract which means you can sell your 100 contracts for $30,000 — from a $2500 investment.  However, as indicated above, if you instead were wrong and C closed under $4, then the option is worthless.  Buying the shares you would break even if the stock didn’t move, but with options you lose your entire investment. However, if you are proven right, then you make far more with the call options versus just buying the stock.

A put option works in the same way as a call option except instead of giving the right to buy a stock it gives you the right to sell it.  Therefore, you purchase put option contracts on a stock you think will go down.  This is a different scenario than call options because the alternative to put options is to sell short the underlying stock which is even more risky than the put options.

All highly traded stocks have a wide array of both call and put option contracts with various strike prices and expiration dates.  This gives you ability to buy a contract based upon how high (or low with put options) you think the stock will go, and how long it will take.  These examples all relate to how options can be used to speculate in pursuit of large returns.  As indicated, they can also be used as a conservative tool in order to hedge risk.  We will further explore these strategies in future articles within this special HardyMag financial series.

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