Options 1: Basics
What Are Options?
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Options are one of several forms of derivative investment vehicles. That is, they |
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Put simply, an option is the right, but not the obligation, to
purchase or sell a fixed number of shares in a stock at a fixed price per share,
at any time up to a fixed date of expiration of the option. In order to obtain this
right, the option purchaser will pay what is known as the option “premium”.
We begin the explanation of options on stocks with a little story:
Once upon a time, George moved into a brand new neighborhood.
In fact, his was one of the first houses in the development. Shortly
after moving in, George noticed that his friends were asking about
the development. They liked the location and the quality of the
homes. George soon became convinced that the price of the
remaining lots would appreciate well in the near future.
Being a shrewd fellow, George said to his wife Paula one evening,
“Baby, I’ve got a good feeling about this place. Why don’t we buy
five or ten of these lots and then turn around and sell them in a
year for a nice fat profit?” Paula gave the correct answer by
replying, “Because we don’t have $600,000 cash this week, and
we are mortgaged to the hairline with the house we’re in!
George, ever the positive and resourceful one, deftly responded,
“Then we can just get an option on the lots.”
Staring at George with new found respect and awe the now attentive
Paula could only respond with “Wow!” Having no idea what
options are, but nonetheless unwilling to admit it, she was for it.
Lets define an option once again: An option (call) is a contract that gives the
owner the right,
but not the obligation, to purchase a security at a specified price
(strike price),
on or before a specified date (expiration date).
When trading options, the idea is to take advantage of the incredible leveraging
power of options. By making a relatively small investment in options,we can control
a much more valuable block of associated stock. In this way we receive the benefit
of the potential appreciation of that asset without owning it outright.
right to buy each lot for $60,000, on or before a date one year in
the future. His total cash outlay for the ten lots was $10,000.
George now had control of $600,000 worth of land with only
$10,000 of risk capital.
The expectation is that the market price of each lot will grow to $61,000 or
more, on or before a date one year in the future. $61,000 would be the break
even point,allowing enough appreciation to pay for the option. Any
increase
in price above $61,000 would be pure profit.
Time quickly passed, and George found that he had two months
left before his options expired. George also found, to his delight,
that one of the lots still owned by the developer just sold for
$68,000. Yes, George realized that he was sitting on a $70,000
profit,($8,000 appreciation per lot =$80,000 less the $10,000
options premium =$70,000) but the same problem his wife Paula
pointed out earlier was still there. George and Paula simply didn’t
have $600,000 or the credit to obtain it in order to buy the lots
from the developer and then sell them on the open market for
$68,000 each..
Realizing that he had only two months left before he had to
exercise his options or lose his $10,000, George went to talk to the
local bank president. The ensuing conversation seemed to confirm
what George had feared. He was going to have to just let the
options expire, losing his $10,000.
Just as all seemed lost, George noticed the bank president
reaching into his coat pocket. Pulling his checkbook out, the
friendly banker said, “Tell you what George. I’ll pay you $2,000
apiece for your options.” Feeling a bit stunned, it soon became
clear to George that the banker was not necessarily doing him a
favor. George realized that the banker could pay him $20,000 for
all ten options, buy the lots, and then sell them on the open
market himself. The banker’s profit would then be $60,000.
George further realized that the banker would have to invest
$620,000 to get his $60,000 ($8,000 appreciation per
lot=$80,000-$20,000 paid to George=$60,000). The banker would
make 9% on his short term investment. He might even hold the
lots for awhile in the hope of making a bigger profit.
Continuing his mental math exercise, George was stunned to
realize that even though his profit wasn’t as big as the banker’s, he
was in fact making 100% on his investment!
Each option contract controls a fixed number of shares in the underlying stock.
This number will vary depending upon which stock exhchange or country you are dealing
with. For example in Australia options listed on the ASX control parcels of 1000
shares, whereas in the US options contracts control 100 shares of the underlying.
This is something to be mindful of.
The two types of options
available: calls and puts