101-12 Stock Options – How do they work?

Stock Options

Options, share some similarities with futures contracts and with common stocks, but they are inherently different.

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Options are simply a contract; you do not own the underlying stock that determines the value of your options contract.  Unlike stocks which you can hold indefinitely, options contracts all have an expiry date, and the closer to the expiry date you get, the less your option is worth.

As you do not own the stock only a promise to pay the difference between the stock price now and the stock price at some point in the future, you will see that the options contracts cost as little as 2% to 20% of the cost of owning the stock.

Stock Options are simply a vehicle to achieve a goal.  For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

The best way to understand options is to run through an example.

Stock Options versus Stocks

For example, you have $1,000 to invest.

Strategy 1 – Buy the Stocks

You could buy five shares of Amazon Inc. (Ticker: AMZN) at $200 per share.

Total Costs $1000

If Amazon moved up 10% over the next 2 months to $220 your profit would be

($220 – $200) = $20 per share.  5 Shares * $20 = $100

A 10% gain.

Strategy 2 – Buy Options on the Stock

You could buy one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2013.  The contract value is $10 per share.  Because you will control 100 shares with each contract and you buy one contract, your costs for the trade are $1000.

In options speak:

  • One contract means you will have control over 100 shares of AMZN
  • At the money means the strike price of $200 per share is equal to the actual stock price.
  • The strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In the same scenario as above, the stock price moves 10% to $220.  The difference in price is $20 per share.  The contract was at a strike price of $200, therefore $220 – $200 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000, a $2000 gain from a $1000 investment.  This means a gain of 100%.

I say theoretically because when you buy an option, the clock starts ticking on the time value.  If the stock price took until the final month before expiry to move to $220, then you would have lost all of the time value of the contract, which could reduce your profits.  However, if the stock had moved 10% in a single day, you would have secured almost all of the 100% and also kept much of the time value in the stock.

What are the risks of options, compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment.  With stocks, this is quite rare; stocks rarely move to zero unless the company goes bankrupt.

If the stock price does not move at all in the time period, your investment can also expire worthlessly.

The stock needs to move in the direction you place the bet to make a profit.  If the stock price moves sharply, your earnings can be quite large.

Strategy 3 – Shorting stock using options

Using the same scenario, but instead of us expecting the stock to increase in value, we expect it to decrease.

AMZN has a current stock price of $200

You could buy one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21, 2013.  The contract costs $10 per share, and there are 100 shares in a contract.  The cost of investment is $1000.

In options speak:

  • One contract means you will have control over 100 shares of AMZN
  • “At the money” means the strike price of $200 per share has already been reached.
  • The strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In this scenario, the stock loses 10% in value to $180.  The difference in price is now $20 per share.  The contract was at a strike price of $200, therefore $200 – $180 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000.  This means a gain of 100%.

Options Summary

Options are a complex instrument, but the more you understand them, the more they make sense.  With experience, you will see that they are an incredibly flexible investment tool.  However, before even thinking about trading options, you will need to understand how to pick stocks, evaluate market direction, and formulate a strategic, systematic approach to investing.  Options will be discussed in more depth in a future lesson.

Summary

Now you know why the futures market exists; you also understand the basics of stock options.  Now it is time to look at commodities.

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