A mini-course in stock options.
Options are contracts that give the contract holder the right, but not the obligation, to buy or sell 100 shares of stock at a given price, called the strike price, at any time before the expiration of the contract which is always the 3rd Friday of the specified month. A call option gives the call holder the right, but not the obligation, to buy at the strike price and a put gives the holder the right, but not the obligation, to sell at the strike price. Options are a form of derivative, because their value derives from an underlying stock, so they reflect the underlying stock. So if there is a stock split, then the corresponding options also split: Example for a 2 for 1 stock split: A Feb 120 call becomes 2 Feb 60 calls. However, a stock option doesn't pay dividends nor does it give voting rights. Examples of Dell options (all examples in this post are based on Dell's closing price of 65 1/4)(Note: This was written some time ago, and doesn't reflect current prices; nonetheless, the principles still apply.):
Option: Feb 65 Call
Option Symbol: DLQBM
Strike Price: 65
Expiration: Feb 22, 1997
Bid/Ask: 4 2 / 4 7/8
Option: Feb 65 Put
Option Symbol: DLQNM
Strike Price: 65
Expiration: Feb 22, 1997
Bid/Ask: 4 1/8 / 4 2
To buy one contract of Feb 65 calls would cost $487.50 (4 7/8 X 100), plus commission, which is usually more than buying 100 shares of stock. Buying 100 shares of the stock would cost $6,525.00.
(1) Each stock has a root option symbol that denotes all options on that particular stock. Dell's root symbol is DLQ.
(2)The next letter denotes both month of expiration and whether it is a call or put. A-L indicates a call, M-Z, a put. For a call, A, the first letter denotes January, E, the fifth letter denotes the fifth month, May. For a put, M, the first letter in the range M-Z denotes January, and Q, the fifth letter in the range, denotes May.
(3) The fifth letter indicates the price, but you can't determine the price by looking at the letter. It simply denotes its position in a series of prices. Thus, the fifth letter in Feb calls for strike prices 60, 65, 70 are L, M, N. This is complicated by stock splits, which I won't get into here, but that is the general idea.
(4) For the 65 strike price, a call allows you to buy Dell at 65 regardless of the stock's market price, and a put allows you to sell at that price.
(5) The expiration date is actually a Saturday, but since the market isn't open then, you either have to sell, or in options parlance, close your position by Friday, or exercise the option.
(6) The bid/ask spread is usually much larger than the spread between stocks, because the volume is much lower. However, spreads may narrow on Monday, January 20 when the new market display rules that the SEC has mandated take effect. The bid/ask spread is lower with options that are close to expiration because there is more volume. The commission to buy and sell contracts is also higher than it is for stocks.
(7) Commissions and market-making costs for options is higher than for the corresponding shares of stock.
Options have intrinsic value and time value. Intrinsic value is the difference between the option's strike price and the stock's current market price, if the current stock price is above the strike price for a call, or below the strike price for a put. Example: A Feb 60 call has an intrinsic value of 5 1/4, based on Dell's current price of 65 1/4. A Feb 60 Dell put has no intrinsic value. A stock option is said to be in the money if it has intrinsic value; if the strike price and stock price are equal, then it is at the money, and if the option has only time value, but is not at the money, then it is out of the money. A call has intrinsic value if the stock is higher than the strike price, and a put has intrinsic value if the strike price is higher than the stock. A stock that is at or below the strike price of a call, or at or above the strike price of a put has no intrinsic value. It only has time value. Thus, a Feb 60 call and Feb 70 put for Dell are both in the money, but a Feb 60 put is out of the money and a Feb 70 call, likewise. But note that a Feb 70 call still costs you money to buy, because even though it is out of the money, an option also has time value, also called a premium. A Feb 70 call would cost you 2 3/4. Thus, its time value is 7 2 (70 + 2 3/4 - 65 1/4). The time value for a May 70 call is 11 3/8. This shows that time value declines as the time left until expiration decreases, explaining why both May calls and puts are more expensive than Feb calls and puts for the same strike price. The more time left in the option, the better the chance that the option will become profitable, and so, it commands a higher premium.
Additional facts about options.
(1) As options become increasingly in the money, they lose more and more of their premium, and start to track the stock dollar for dollar.
(2) When options are out of or at the money, they increase less on a dollar basis than the underlying stock, but they increase faster on a percentage basis. Example, using rough numbers: An Intel Feb 160 call costs $3 / share when Intel was at 138. Intel rises to 146 in a few days and the call rises to $4 / share. So Intel rises by $8 / share, but the option rises by only $1, but this $1 / share was 33 1/3% rise in the option price. If the stock rose by the same amount, it have to go up by $276! However, if the stock rose to $146 slowly, then the time value might decline faster than the positive effect of the rising stock price. This is one of the things that makes options tricky.
(3) The decay of the time value is nonlinear. In other words, the time value declines slowly at the beginning of the life of the contract, but decays rapidly as expiration approaches, especially in the last 2 weeks.
Profiting with Options. Profits are obviously made by buying low and selling high. Calls increase in value as the underlying stock price increases. Puts increase in value as the underlying stock price declines. You would buy a call the same way you buy the stock: you try to buy it when you think it is at its lowest price. You buy a put however, when you think the underlying stock is at its highest price, because then any given put will be at its lowest price.
The advantage of options are numerous.
(1) It is much cheaper buying the option than the stock. Thus, rather than buying Dell for 65 1/4 per share, you can buy the Feb 65 call for 4 7/8 per share, and the May 65 call for 8 1/2. Two additional advantages: (a) you can buy stocks that you wouldn't ordinarily be able to afford, like Intel at 143 per share. (b) You can diversify more, thereby lowering your risk. This not only includes buying options for different stocks, but also buying puts and calls. Thus, you could buy calls on strong stocks and puts on weak stocks. If the market goes up, you make money on your calls; if the market goes down you make money on your puts. Because options can appreciate much more than they can decline, the only way you can lose money with this strategy is if the market stays the same. When does that ever happen?
(2) Your risk is limited. If you buy Dell at 65 1/4, and it declines to 30, then you're losing 35 1/4 per share. On the other hand, you can't lose anymore than your investment with options. Thus, you can't lose any more than the 4 7/8 per share you paid for the Dell Feb 65 call. But herein lies the risk with options. Whereas, there is little chance that you will lose your entire investment by owning the actual stock, unless, of course, you bought on margin, you can easily lose your entire investment in options. In fact, if the option moves increasingly out of the money as expiration approaches, you will probably lose your entire investment! Once an option expires, it becomes completely worthless, it ceases to exist! The key to lowering risk with options is to not invest everything you have in options, but just a small part.
(4) The potential for profits is much greater with options than with stocks. The key to making BIG money in options is to buy cheap and to buy short. I wouldn't buy a Dell May 65 put, because May is too far off, and therefore would command a high premium, and a 65 strike price would be too expensive since it is at the money. The key is to try to determine what you think the stock will go to during the option's lifetime, and then try to buy at a strike price that is somewhat above that. Example: CHPS. I only have rough numbers here, but they are good enough to illustrate the idea. Before CHPS came out with earnings, it was around 21 1/2. When earnings came out it went down to about 16. When CHPS was above 21, the Jan 17.5 put for CHPS was probably about 1/16. It was cheap because expiration was so close and it was way out of the money. However, when the stock declined by more than $5, the put started to increase in value quickly. If CHPS was 16, the put would have an intrinsic value of 24/16 (1 1/2), so by closing your contract then, you would have profited 2400%. A $500 investment would have returned a profit of $11,500 in one day! You could never earn that kind of return on a stock even if you held it for a whole year! On the other hand, you couldn't lose any more than 100% of your initial investment, or in this case, $500.
To illustrate how I would use options to make money, let's consider the Dell put. The first thing that I would consider is, did Dell reach its highest price for the immediate future, let's say within the next month. Because this is earnings time, and stocks usually do well as earnings are being reported, I would not consider buying a put now, especially since it will be another month until Dell reports earnings, and it would probably rise a little more then, so I would wait until then to buy a put. Then I would project stock prices for the near future. Let's say I think Dell will go to 70 to 75 and then retreat to $55 again. I would wait until the stock reached what I consider to the maximum price for the next few months, then buy a put for a strike price of about 60 or 65. I would buy at these strike prices because these puts would be extremely cheap ($2 or less), and when the stock falls below the strike price, the value of the put would increase rapidly. So if I buy 65 puts for $2 and it does go down to $55, then the intrinsic value would have to be at least $10, a 500% increase in my investment, and the option would still have some time value, so it would actually be worth more yet. If I bought a 75 put when the stock was at 74, then that put would probably cost me about $6, so if it went down to $55, I would earn more money per share, but since I would have fewer shares for the same amount of money, the percentage increase would be less. In this case, the intrinsic value of the put would be about $14, an increase of 233%. Still a nice increase, but less than I achieved with a cheap put. But, on the other hand, suppose I was wrong and the stock price only went down to $69. Then I will profit more with the 75 put than with the 65 put. Note that I didn't specify a month. I would have to buy an option for the time span that I am considering, but unfortunately there isn't a stock option that expires for every month. However, there are always contracts for the current month and the next month, and as contracts expire, new contracts are added. Example: Right now, there are Feb and May options for Dell, but not March and April. So this is yet another thing that you have to consider. Since I don't think Dell will decline considerably before Feb expiration, I wouldn't buy a Feb put.
If I were going to buy a call, I would try to buy right before I think there will be significant appreciation, like during earnings announcements, for instance, or during annual meetings.
So you see, options can be very profitable, but because of the time limitation, they can be extremely tricky, and that's why they are risky. If you would want to do this, first of all, read as much as you can to learn options thoroughly. Much of this reading you can do on the Internet. Some good places: optionscentral.com and options-iri.com.
How are options valued? The Black-Scholes formula: options-iri.com.
There are many other places as well. Use Yahoo or other indexes to find out more.
Most importantly, if you do decide to try options, do simulated trading, without actually buying anything. This way you will learn just how tricky options are. Also, when you do start making purchases, just buy a few contracts at a time, and buy cheap contracts. This way you greatly diminish your risk while testing your ability to make a profit with options. Good Luck.
Written by William C. Spaulding in January, 1997, with some later modifications.
Please consider this as a bare introduction. There is no attempt here to consider everything, since there is no room. In particular, no consideration is given to writing puts and calls, or esoteric aspects of options. I'm thinking about writing an electronic book on the subject, however, that will be much more detailed. I'll let you know about that later.
|
