Perhaps an easy explanation is the following:
An equity option is the right to "purchase" (call) or "put" (put) 100 shares of a stock to someone in the future at a given price (strike price) and until a given time (expiration date).
To keep it simple I will try to keep it in round numbers and only consider the option cost and not any commission (which generally runs about 27 dollars for the first contract and an additional 2 dollars for each additional contract.
For example: let's set up a hypothetical; say I purchased an option on Broadcom, We will only discuss how one of these works.
When the stock was about 97 a week ago, say I bought an August 100 "Call" on BRCM for 11 7/8. What this means is that I purchased the right to "call away" 100 shares of Broadcom from another person who received the premium I paid, which was $1187.50 for $100 a share anytime between that day and the 3rd Friday of August at expiration time. In other words, another individual, trading in the option exchange "wrote a call" (sold a call) guaranteeing to deliver 100 shares of Broadcom for 100 dollars a share until the 3rd Friday in August. In return that person received the premium I paid---- $1187.50---and agreed to surrender the upward potential to me. If the stock goes nowhere, he keeps the premium and I am out 1187.50; but if the stock goes up, as it has, the option increases in value----for example that same call is worth today, at the close of trading $2187.50. So I would be able to sell the option back to the option market for a net gain of $1000 today or 84.21 % on my investment in about 2 weeks.
The advantages of options is that they provide LEVERAGE----you can make a bundle, you can lose a bundle----RAPIDLY.
but what many fail to notice is that options were originally constructed to "hedge" positions or provide a buffer to risk.
For example: in the above example----no matter what happened with Broadcom, I could only lose $1187.50 if I only had one contract----no more; NO MARGIN CALLS; and with the added leverage provided by an option, a person without great amounts of money can still play the great and expensive stocks-----just think, you could have control over the upside potential of 100 shares of Broadcom, WITHOUT FORKING OVER $9700 DOLLARS. That is quite a benefit.
On the "put" side, you could ensure your portfolio by buying "protective puts" 1 put for each 100 shares of stock either with "strike prices" just under the value of the stock or perhaps several points lower ( this functions as a sort of "insurance" and in the more "out of the money puts" further below the strike price, serve as a form of a deductable)
Now Leaps are long term options which expire on the 3rd Friday of January of either the year 2000 or 2001. With Broadcom, these are incredibly expensive due to the really high "Beta" (fluctuation) value of Broadcom which is one of the factors entering into the price of the call or put. For Example the highest priced "Call Leap" on Broadcom is currently the (LGJAB) which is a Jan 2000 Call on Broadcom with a Strike Price of $110. This means that you have purchased the right to buy 100 shares of Broadcom anytime between now and the 3rd Friday of January in the year 2000 for $110 a share. For this Leap, the price is $2937.50 plus $27 commission----additional Leaps commission only $1.50------now, if Broadcom stays flat or loses share price, you stand to lose $2937.50----but you will not get any margin calls and your loss is FIXED. Whereas, your upside potential is "unlimited". If Broadcom goes up to $170 a share by Jan 21,2000---you will be up $6000 minus the cost of the Leap--------usually the great moves take place while the Leap is still in effect and the price of the Leap appreciates along with the runup. For example, if Broadcom goes up, and it is possible, to 170 by November, your Leap could be worth somewhere around $8000 bucks right then; and you can always sell it anytime until the 21st of January to the option market for the going bid on the Leap itself.
With options you need never purchase the underlying stock; you can trade the options (or Leaps) directly with the Options exchange through your broker-----it is just as fast, if not faster, than trading stocks----so the liquidity is there and one need never take physical possession of the stock itself; nor need one ever "put" their own shares to the other party (unless you choose to "unload" them)----you can merely sell the call or put "to close" and your position will reflect the gain or loss.
I hope I haven't confused anyone; but Leaps on less volatile stocks are much less expensive. But the upside potential of explosive stocks like Broadcom is incredible as my longlost (I sold it) August 60 Call on Broadcom which I bought for 1400 dollars a couple of months ago when the stock was about 60. This same option I could now sell for $5,375 dollars----and I would still have two months of time left to see if Broadcom is going higher. Meanwhile, being "DEEP in the MONEY" every point up on the stock equals another $100 of value added to the value of my option----so if Broadcom goes up another 30 points, tack on about $3000 bucks.
PS---options achieve "parity" when the price of the stock equals the strike price you own + the price of the premium you paid----from there on, you are a winner even if you sell on options expiration day. |
