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Stock Options

A stock option is a contract that gives the holder the right to purchase or sell shares of a security at a specified price (strike price) on or before a given date (expiration date). This is a risky instrument! Forget the rhetoric for a minute; options are a gamble. The option marketplace is very orderly and efficient, making trading these instruments easy. There are classes, books, seminars, TV shows, websites and companies that can help train someone in the option markets. Nevertheless, options are highly leveraged financial instruments that carry extreme risk. You can lose all of your investment overnight. The fact that the cost basis of options is less then the underlying securities does not limit your risk. A lot of small losses can add up to a significant loss.  Once the time elapses, when the exercise date passes, the option is worthless and the premium spent for the option is gone forever. Options are classified as derivatives because the price of options is dependent on the value of the underlying securities. They are also called wasting assets. With stocks, you are buying an ownership position in a company. If your initial decision is not great, which happens often, time may be able to cure your mistake. With options, you don’t have room for timing mistakes.

"Fair is Fair" that is why the back dating of employee stock options by corporations should be prevented. On a more positive note, there are many other valuable uses and benefits of options.

Calls versus Puts

A call option gives the holder the right to buy the underlying security at the strike price, on or before the expiration date. The holder of a call option is betting that the security will increase in value and exceed its strike price. The holder can then call in the security for a profit. A put option is the reverse of a call option; it gives the holder the right to sell the security at the strike price, up to the expiration date. The holder of a put option is betting that the security will decline below the strike price. This way, he can “put” the stock to the counterparty.

Option Styles

Exchange traded options are usually “American-style,” where the holder can exercise his option any time before the expiration date of the option. However, there are also “European-style options, where the holder is limited to exercising his option to a specified period of time. A “capped-style” option is where the holder of the option is limited in potential profit by a price cap. If the stock price reaches the cap, the option is automatically exercised. In the case of a call option, the cap price is equal to the strike price plus the cap interval. With a put option, the cap price is equal to the strike price less the cap interval.

Strike Price

This is the exercise price for which the underlying security can be purchased, as with a call option, or the selling price in the case of a put option. When the underlying security is at the strike price it is considered to be “at-the-money”. An “in-the-money” option is one that has intrinsic value. An “out-of-the-money” option is one with no intrinsic value.

Intrinsic Value and Time Value

Intrinsic value is the dollar amount of the option that is in-the-money. In the case of a call option that is in-the-money, it is the difference between the strike price of the option and the higher market value of the underlying security. It excludes any premium for the time value of the option. With a put option, it is the difference between the strike price and the lower market value of the underlying security.

Time value is the difference between the premium on the option and the option’s intrinsic value. It’s the portion of the premium that is attributed to the time value of the option.

Example

What makes options and puts so appealing is leverage. Let’s use Pfizer as an example: on 7/6/05 the stock was selling at $26.85 and their August 27 ½ calls traded at 75 cents. Thus a 100 share contract cost $75 plus commission. Options expire on the third Friday of the month, in this case August the 19th. (They actually expire on the third Saturday of the month, but the markets are closed.) If you were to buy 100 shares of the stock, it would cost $2,685. If the price increased to $30 one would have a profit of $315 or an 11.7% increase. Now, if you purchased the $27 ½ (strike price) calls for 75 cents, and Pfizer increased to the same $30 per share, prior to August 20th  your profit would be $175 or a 233% increase. The profit (or loss) is based on the strike price plus the premiums paid, compared to the market value ($27 ½ +.75 = $28 ¼ - $30) or $1.75 profit per share, times 100 (number of shares in one option contract) = $175. Options are written on blocks of 100 shares. That’s a lot of leverage! Look at the difference in your return: if you purchased the stock the return was 11.7%, but by using options the return was 233%. That’s the benefit of leverage; for $75 you controlled $2,685 worth of stock. Pfizer’s January 06, $27 ½ options costs $1.50 and their January 07, $27 ½ Leaps cost $2.80. LEAPS are long-term options with an expiration date up to three years in the future. The longer out one goes, the more expensive the option. The risk is that if Pfizer stays flat until the option’s expiration date, the option holder loses 100% of his investment, while the stock holder maintained his investment. Options are all about timing. As a postscript, the January 06 options expired worthless as the stock closed at $24.28 on 1/17/06.

The Underlying Securities

Options are available on individual stocks, stock indexes, currencies, futures contracts, treasury security interest rates and recently, exchange-traded funds.

Selling Calls and Puts

Selling a call option is where one is paid a premium to sell the underlying shares at the strike price, on or before the expiration date. Selling a put is the reverse of a call; one is paid a premium to be ready and able to buy the underlying security at the strike price, any time prior to the expiration date. As a seller, you have no control over whether or not the option is exercised. If investors need to close out their positions early, they need to purchase offsetting contracts.

In writing a covered call, one owns the underlying security and writes a call against it. It’s a nice way to increase the cash return on a stock in a flat or declining market. However, in a bull market there’s a bigger risk of losing your shares at the strike price. Using the same example as discussed above, if one owned Pfizer and sold an option by writing a covered call, the seller would receive a premium of 70 cents. There is always a 5 to 10 cent difference between buying and selling a call.

In writing a covered put one, has a short position in the underlying security and writes a put against it.

A “naked option” is an uncovered option where the writer does not own the underlying security. The issue with naked options is that the writer has an unlimited loss potential if the value of the security substantially changes. This is not a smart move, because for a relatively small premium, one is taking a huge risk.

Quadruple Watching Days

The third Fridays of March, June, September and December are when stock options, stock index options, stock index futures and single stock futures all expire. Trading volume is usually high, as investors close out positions.

Interested in more information on options? Look at Yahoo Finance, at http://finance.yahoo.com. It tracks options by company, and is a good resource for the research of options. Other good sources are the Chicago Board of Options at www.cboe.com, Option Industry Council at www.888options.com and Options Clearing Corporation at www.optionsclearing.com.

Option trading is for the more experienced investor.  There are many successful option strategies; just be careful, because the risks can be high. Options are a form of derivative, and fortunes have been lost on derivatives.

 

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