Options contracts are much-maligned by some investors.
Options, contracts to either buy or sell a stock at a certain price in the future, allow for traders and investors to speculate on the price of a stock without ever actually owning it.
“Options traders have no actual skin in the game. They don’t actually own anything. It’s the sort of rampant speculation that ruins markets.” Or at least that’s the argument from those disgusted by the practice. “A stable market is built on steady, level-headed investors who own equity and are invested in a company’s long-term health,” they would argue.
However, while this assessment is more than justified for many of those trading options, that sort of high-risk behavior only scratches the surface of what options are used for. Options are incredibly flexible financial instruments that have developed a wide array of uses over the years for risk-seeking speculators and risk-averse investors alike; whether that be hedging the exposure of a holding, generating income to maximize returns, or obtaining maximum leverage for a market play.
Calls and Strike Prices
Simply “put,” an option is a way to place a bet about whether the price of a stock will go up or down. There is, however, some terminology that’s necessary to understanding how they trade.
A “call” option is a contract that allows its holder to buy a stock at a certain price at a future date. It’s a way to bet on a stock increasing in price. If you have “call” options to purchase shares of the Acme Corporation at $10 apiece, and the price of Acme goes to $15 apiece, you can exercise your options and then sell shares on the open market for a profit of $5 a share.
The price that an option contract secures for selling shares is called the “strike price.” So, this call option has a strike price of $10.
A single options contract represents 100 shares of the underlying stock. So, if you were looking to get the opportunity to purchase 1,000 shares of Acme, you would buy 10 call options. The contracts also include a set date at which they expire, usually expressed in months from the date they’re written. So, a three-month call option on Acme at a strike price of $10 means you can buy 100 shares of Acme for $1,000 at any point in the next three months.
A “put” option is just the opposite of a call option, allowing its holder to sell a stock at a certain price. If you have 3-month “put” options of Acme with a strike price of $10 a share, and it goes to $5 a share after two months, you can buy shares on the open market for $5 and then exercise your options to sell them for $10. This is another way to short a stock, i.e. bet that it’s going to decline in price. However, unlike a short, it limits your losses without limiting your potential profit.
Pricing and Premiums
So, profitably trading options contracts depends greatly on the length of the option and its strike price. But there’s another key factor: the “premium.”
The premium refers to the price one has to pay to secure the option contract. There’s a massive secondary market used to buy and sell options, and anyone can participate, whether they actually hold any stock or not.
Anyone looking to buy or sell options contracts would either make their way to an exchange like the Chicago Board Options Exchange (CBOE) or trade online though most brokerages. There, sellers can find a party willing to take the other side of the contract they want to write and sell them. And buyers can find someone willing to write them options. That is important, because in order to buy or sell an options contract, there has to be a second party willing to assume the other side of the transaction.
But how much are they? It varies based on the underlying assets and the different variables. The longer the contract lasts for, and the lower its risk profile, the more expensive it gets. The shorter and more speculative plays will ultimately cost less because they’re less likely to be executed or assume any intrinsic value.
So, different combinations of length, strike price, and volatility in the underlying asset can have wildly different values. How do you figure out a fair price? If it was just a matter of haggling with the opposite party, only the shrewdest traders would be able to make the necessary calculations to write and sell the contracts.
That’s why options are priced using the Black-Scholes model. This is a fairly complicated mathematical formula that factors in intrinsic value (more on this later), time decay, risk-free rate, and dividends before running millions of projections of expected outcomes and then finding a fair price based on those projections, the strike price, and the length of the contract.
While it’s difficult to fully understand the entirety of the Black-Scholes model, which has been a standard method for pricing options since the early 1970s, it suffices to say that it creates a fairly reliable model for determining a fair price for options based on the various risk factors and the likelihood of different outcomes.
Putting it All Together
So, once you know the strike price, duration, and premium for a contract, it becomes relatively easy to understand how they trade.
So, you feel pretty confident that shares in Acme are about to take off as the company is about to introduce a new rocket car for chasing road runners that comes with a safety feature that automatically applies the breaks prior to crashing into canyon walls. It’s a bold new product that should mean big gains as it gets traction in the marketplace. Acme is currently trading at $10 a share, but you’re confident it will be at more than $20 in a year’s time.
So, you head to the CBOE where you find someone willing to sell you 12-month call option on Acme with a strike price of $15 for a premium of $100. That’s a solid price, averaging out to just $1 a share, so you pay the $100 and take your contract.
So, in order to break even, you’ll need the shares to reach $16 apiece on the open market. That factors in your strike price of $15 and the $1 a share you paid in premium to secure the contract. Once the price goes north of $16, you’re into the black. Congratulations.
So, as the earnings reports roll in reporting brisk sales of the new rocket car, you sit back smiling as shares roar to $20 nine months into your contract. So you’ll profit $400 if you sell now.1 That is, $20 (the current share price) - $16 (the strike price plus the premium per share) = $4 profit per share. And, with 100 shares to each option, yours will net you $400.
Not So Risky, and That's the Idea
But, let’s say you get greedy. Thinking that it can get as high as $25 a share (giving you a $900 profit), you decide to hold off on selling your options. Then, disaster strikes. It becomes apparent that, while the new rocket cars have dramatically reduced the risk of running into canyon walls, they do nothing to prevent the cars from going off of cliffs, prompting a recall amid swirling scandal as severely injured coyotes across the country sue the company.
It’s a blood bath, shares plummet all the way to $5 in a single day. Ouch.
But here’s where options have some real appeal. While someone holding 100 shares of Acme just lost $1,500 in equity in 24 hours, you’ve only really lost the $100 premium for your contract. Sure, you could have made $400 if you had sold at $20 a share, and it’s going to be hard to forget that no matter how many times you hit your head against that wall, but once the price slips below $15 your potential losses are maxed. You’re out the price of the contract and nothing more even as the losses mount for anyone actually holding stocks.
It’s what can be truly appealing about options: limited risk. Sure, any price increase to less than $16 means you lose your entire premium, but, no matter how bad it gets, you can’t lose more than your premium.
1 It’s worth noting that options are almost never actually executed. Since the contracts themselves can be bought or sold based on their intrinsic value, profitable options are typically sold rather than executed. And, should they actual reach the end of their duration and have value, the person holding the other side of the option typically shells out money for the contract rather than dealing with the hassle of having to actually exchange shares.
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