The large sums of money that can be won or lost over a fairly short period with options make them both intriguing and frightening to many investors. Because of the broad array of esoteric terms and unfamiliar concepts associated with them, options can be a difficult subject for investors to understand. Frankly, we don't think options are for everyone. In fact, many investors have had successful investing careers without ever considering them.
Even if you never end up buying or selling an option, it's a large enough part of the equities market to merit being aware of. You will probably be tempted at some point in your investing career to "take the next step" and leverage your ideas. This lesson will teach you the basics so you know what you may be getting into.
Call and Put options on stocks
At the heart of all the spreads and strategies discussed about options is the call and put. A call gives its owner the option to buy a stock at a specific price, known as the strike price, over a given period of time. A put provides the owner the option to sell a stock at a specific price (also called the strike price), over a given period of time. Let's look at how options are typically represented for a particular stock:
JUN10 50c: This refers to a call option with a strike price of £50 that expires in June 2010. The owner of this call would have the option to purchase the stock for £50 anytime before the option expires in June 2010.
AUG11 75p: This refers to a put option with a strike price of £75 that expires in August 2011. The owner of this put would have the option to sell the stock for £75 anytime before the option expires in August 2011.
What is an option contract?
Options are traded in units called contracts. Each contract entitles the option buyer/owner to 100 shares of the underlying stock upon expiration. Thus, if you purchase seven call option contracts, you are acquiring the right to purchase 700 shares.
For every buyer of an option contract, there is a seller (also referred to as the writer of the option). In exchange for the cash received upon creating the option, the option writer gives up the right to buy or sell the underlying stock to someone else for the duration of the option. For instance, if the owner of a call option exercises his or her right to buy the stock at a particular price, the option writer must deliver the stock at that price.
Understanding option pricing
Two key phrases from our definitions for a call and put are "option to buy" and "option to sell." The owner of a call or put is not obligated to take any action. Thus, a call or put never has a value less than £0 before it expires. Consider the following example:
You own a call that gives you the right to buy a stock for £50. However, at expiration, the stock is priced at £45. Why would you exercise your right to purchase the stock for £50 when you can buy it for less in the stock market? You wouldn't. So, your call is worth $0 anytime the stock finishes below your strike price, which is £50 in this example.
When talking about option prices, people often refer to intrinsic value and premium to intrinsic value. (This intrinsic value has nothing to do with the intrinsic value we refer to when talking about the discounted cash flow of a company.) An option's intrinsic value is the difference between its strike price and the underlying stock price, when it favours the owner of the option. People often refer to intrinsic value as the amount that the option is "in the money." Let's look at three examples, assuming we are in 2010:
1. FEB11 60c when the stock is trading at £75: In this case, you own a call option that allows you to purchase the stock for £60 when it is trading for £75. We would say this call option has an intrinsic value of £15 because it gives you the right to purchase the stock for £15 less than you could purchase it for in the stock market.
2. OCT11 80p when the stock is trading at £50: In this case, you own a put option that allows you to sell the stock for £80 when it is trading for £50. We would say this put option has an intrinsic value of £30 because it gives you the right to sell the stock for £30 more than you could sell it for in the stock market.
3. JUL10 50c when the stock is trading for £40: In this case, you own a call option that allows you to buy the stock for £50 when it is trading for £40. This option has no intrinsic value. It is considered "out of the money."
Let's take a closer look at the third example above. Although it has no intrinsic value, we discover that the option is trading for about £2 in the marketplace. Why is that? Although the option isn't in the money now, there is still some time left (before expiration) for the stock to move such that it could place the option in the money. This is referred to as time value or option value.
In the case of the second example, the option may be trading for £32 even though the intrinsic value is only £30. In this case the option is trading at a £2 premium to its intrinsic value. This premium is also known as the time value.
Drivers of option value
There are several key factors that influence the value of an option. First, the level of volatility in the underlying stock plays a key role. The higher the stock's volatility, the greater the value of the option. If the underlying stock is more volatile, it means the option has a greater chance of trading in the money before the option expires.
Second, the amount of time left until the option expires influences the option's value. The more time left until expiration, the greater the value of the option. Again, the longer until expiration, the more time for an option to trade or finish in the money.
Finally, the direction the underlying stock trades will affect the value of the option. If a stock appreciates, it will positively affect call options and negatively impact put options. If a stock falls, it will have the opposite effect.
Basic options strategy – Leaps
There are literally scores of option strategies. Straddles, strangles, and butterflies are just some of the main types of strategies where an investor can use options (or sets of options) to bet on any number of stock and market movements. Most of these are beyond the scope of this lesson, so we will just focus on two strategies most often used by value investors.
First, leaps are options with relatively long time horizons, typically lasting for a year or two. (The term "leaps" is an acronym for "long-term equity anticipation securities.") Some value-oriented investors like call option leaps because they have such long time horizons and typically require less capital than buying the underlying stock.
For example, a stock may be trading for about £60, but the call options with two years to expiration and a £70 strike price may trade for £10. If an investor thinks the stock is worth £100 and will appreciate to that price before the leap expires, he or she could find the leap very attractive. Rather than spending £6,000 to purchase 100 shares of the stock, he or she could buy one leap contract for £1,000 (1 contract x £10 x 100). If the stock closes at £100 at expiration two years from now, the leap position would return £2,000 (1 contract x (£30 – £10) x 100). This would mark a £2,000 profit on a £1,000 investment (200%). However, if he or she had simply purchased the stock, it would have marked a £4,000 profit on a £6,000 investment (67%).
As we see above, leaps can offer investors better returns. However, this bigger bang for the buck does not come without some additional risks. If the stock had finished at £70, the leap investor would have lost his/her £1,000 while the stock investor would have made £1,000. Also, the leap investor doesn't get to collect dividends, unlike the stock investor.
Let's also consider a case where this stock trades at £70 at the leap's expiration, but then goes up to £110 soon after expiration. The owner of the stock enjoys the appreciation to £110, but the option holder in our example is out of luck.
This latest example highlights perhaps the reason why options are a tough nut to crack for most investors. To be successful with options, you not only have to be correct about the direction of a stock's movement, you also have to be correct about the timing and magnitude of that movement. Deciding whether or not a company's stock is undervalued is difficult enough, and betting on when "Mr. Market" is going to be in one mood or the other adds great complexity.
Another strategy – Baby Puts
Baby Puts refer to put options that are far out of the money, and therefore trade cheaply. Investors will sell these baby puts on stocks that they are comfortable purchasing at a specific price, which will be the strike price of the put they are selling. Typically, this is the price that builds in a margin of safety to their estimate of the stock's fair value.
For example, say an investor would be happy to purchase Rio Tinto for £35 per share, but the stock is trading at £45. It's currently January, and the investor notices that the May £35 put options are trading for £1. The investor decides to sell (write) the May £35 put options for £1. This means the investor collects £1 for selling the right to someone else to sell the investor the stock for £35 anytime before the option's May expiration date. So, if Rio Tinto stock doesn't fall below £35 by the May expiration, the investor pockets the £1. However, if the stock falls below £35 before May, the investor will probably be required to purchase Rio Tinto stock for £35, because the person to whom he or she sold the put option will exercise his or her right to sell the stock for £35.
Value investors might be willing to partake in this strategy because they decided in advance that £35 was a good price to purchase Rio Tinto stock. And, if the stock doesn't fall below £35, they get to collect £1 (by selling the baby put) as they wait for Rio's stock to trade cheaper.
This strategy is not without some fairly large risks. If the investor doesn't have enough cash in his or her account to purchase the stock, the investor's broker may require additional funds be deposited. We'd recommend considering this strategy only if an investor has plenty of cash on hand. Also, a fresh piece of news could surface (between the time the investor sells the put and the put expires) that might change the investor's opinion of the fair value of the stock.
The bottom line
Some investors like options because they require less capital and thereby offer potentially greater returns. Others like to use them to execute strategies like the baby put example above. However, options also possess risks that will repel many investors, and rightfully so, in our opinion. Like we mentioned earlier, one can have a very successful investing career without spending a moment thinking about options.
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