Stock Option Basics Explained

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Contents

Stock Option Basics

Definition:
A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

Option Contract Specifications

The following terms are specified in an option contract.

Option Type

The two types of stock options are puts and calls. Call options confers the buyer the right to buy the underlying stock while put options give him the rights to sell them.

Strike Price

The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It’s relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option’s premium.

Premium

In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.

Expiration Date

Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month.

Option Style

An option contract can be either american style or european style. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised anytime before expiration while european style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are american-style options.

Underlying Asset

The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities.

Contract Multiplier

The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares.

The Options Market

Participants in the options market buy and sell call and put options. Those who buy options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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Learn the Basics of How to Trade Stock Options – Call & Put Options Explained

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The highs and lows of stock market investing can be nerve wracking, even for the most experienced investors. Taking risks with your money is always a source of anxiety. Fortunately, there are some investment risk management strategies you can utilize when pursuing larger investments in the stock market.

One way you can gain access to the market without the risk of actually buying stocks or selling stocks is through options. Because options trade at a significantly lower price than the underlying share price, option investing is a cheaper way to control a larger position in a stock without truly taking ownership of its shares. The strategic use of options can allow you to mitigate risk while maintaining the potential for big profits, at only a fraction of the cost of buying shares of a stock.

What exactly is an option? An option is the right to buy or sell a security at a certain price within a specified time frame. Rather than owning the shares outright, you’re making a calculated bet on the future of a stock’s price within the time period specified by the option. The best thing about options is that you have the freedom to choose whether or not to exercise them. If you bet wrong, you can just let your options expire. Though you’d lose the original cost of the options, you also avoid the hefty losses you would have otherwise incurred had you paid full price for the stock.

With all this talk about how great options are, it seems like everyone should buy options, right? After all, they’re cheaper and have lower risk. Well, not so fast. Don’t forget about two things:

  1. the limited-time aspect of options
  2. the fact that you don’t actually have ownership of the stock until you’ve exercised your options

I’ll delve further into these risks in the context of the examples below for both call and put options.

Now, here is a detailed analysis of the two basic types of options: put options and call options.

How Call Options Work

When you choose a call option, you’re paying for the right to buy shares at a certain price within a specified time frame. Consider an example in which shares of Nike (NYSE: NKE) are selling for $90 in July. If you think that the price will increase over the next few months, you could buy a six-month option to purchase 100 shares of Nike by January 31 at $100. You would pay roughly $200 for this call option assuming it costs about $2 per share (remember that you can only buy in 100 share increments when it comes to options), which would in turn give you the option to acquire 100 shares of Nike anytime within the next six months. Compare that to the $9,000 you would have paid had you wanted to buy the shares outright ($90 multiplied by 100 shares) and the difference is significant.

Scenario 1: On December 10, if shares of Nike are trading at $115, you can exercise your call option and net a $1,300 gain (the $15 profit per share multiplied by 100 shares minus the $200 original investment). You could alternatively choose to make a profit by re-selling your option on the open market to another investor. This will often lead to a similar gain.

Scenario 2: If, however, Nike’s share prices fell and never reached $100 during the six-month period, you could just let the option expire and save your money. Your only loss would be the original $200 cost.

Risks

Now, let’s analyze the potential risk of investing in options. First, in Scenario 1 where Nike’s shares never reach $100 and you lose the entire $200 original investment, what was your percentage loss? 100%! As bad a day or year as anyone has had in the market selling stock, you’ll rarely find someone who has incurred a 100% loss. The only way this can happen is if the underlying company went bankrupt and their stock price went to zero.

As you can see, options can lead to huge losses, especially when you analyze it from a percentage point of view. To further illustrate this point, let’s say Nike’s share price was $99 on the last day you could exercise your options. Of course, you wouldn’t exercise them because you would lose a dollar on every share. But what if you had instead invested $9,000 for the actual stock and owned 100 shares. Well, on this day that marked six months out from the original investment, you would have a 10% gain ($99 versus $90). Imagine that: a 100% loss (options) vs. a 10% gain (stock). As you can see, the risks of options can’t be overstated.

To be fair, the opposite is true for the upside. If the stock was trading at higher than $100, you would have a substantially higher percentage gain with options than stock. For example, if the stock was trading at $110, that would imply a 400% gain ($10 gain compared to the original $2 investment per share) for the option investor and a roughly 22% gain for the stock investor ($20 gain compared to the original $90 investment per share).

Lastly, with owning stock, there is nothing ever forcing you to sell. For example, if after six months, the shares of Nike have gone down, you can simply hold onto the stock if you feel like it still has potential. A year later, if it’s gone up drastically, you’ll make a significant gain without ever having incurred any losses. However, had you chosen to invest in options, you simply would have been forced to incur a 100% loss after six months with no choice to hold onto it even if you feel like the stock will go up from there.

Thus, as you can see, there are major pros and cons of options, all of which you need to be keenly aware of before stepping into this exciting investing arena.

How Put Options Work

A put option is the exact opposite of a call option. This is the option to sell a security at a specified price within a specified time frame. Investors often buy put options as a form of protection in case a stock price drops suddenly or the market drops altogether. Put options give you the ability to sell your shares and protect your investment portfolio from sudden market swings. In this sense, put options can be used as a way for hedging your portfolio, or lowering your portfolio’s risk.

In this example, you own 100 shares of Clorox (NYSE: CLX) stock, which you purchased for $50 a share. As of January 31, the stock has gone up to $70 per share. You want to maintain your position in Clorox, but you also want to protect the profits you’ve made, just in case the stock price drops. To fit your needs, you can buy a six-month put option at a strike price of $70 per share.

Scenario 1: If Clorox stock takes a beating over the next few months and falls to $60 per share, you’re protected. You can exercise your put option and still sell your shares for $70 each even though the stock is trading at a significantly lower price. And if you feel confident that Clorox stock will recover, you could hold onto your stock and simply resell your put option, which will surely have gone up in price given the dive that Clorox stock has taken.

Scenario 2: If, on the other hand, shares of Clorox kept climbing, you’d let your option expire and still reap the benefit of the increased value of the shares you own. Yes, you’d lose out on what you invested into the options, but you still haven’t lost the underlying stock. Thus, one way to look at it in this example is that the options are an insurance policy which you may or may not end up using. As a quick side note, you can buy put options even without owning the underlying stock in the same manner as call options. There is no requirement of owning the stock.

Risks

The exact same risks apply as detailed in the Call Options section above. Buying the put options has the potential for a 100% loss if the stock goes up, but also the potential for huge gain if the stock goes down since you can then resell the options for a significantly higher price.

Final Word

Options are a great way to open the door to bigger investment opportunities without risking large amounts of money up front. But remember that trading options is for sophisticated investors only. If you’re a new trader with an online account, don’t try this on your own unless you’ve talked with a professional and are comfortable with the basics.

This warning arises out of the fact that options trading comes with plenty of risk which have been detailed above. These transactions are about proper timing, and they require intense vigilance. Sophisticated investors have enough experience to be familiar with options strategies and have the comfort level necessary to use them. If you’re not careful and miss the right time to exercise an option, or your initial bet simply doesn’t work out, you can lose a ton of cash in the form of 100% of your initial investment. Also, options are just a part of an investing strategy and should not represent an entire portfolio.

Have you taken advantage of put or call options? Do you have any interesting success or failure stories? Tell us about your experience with options in the comments below.

Understanding Your Employee Stock Options

Many companies issue stock options for their employees. When used appropriately, these options can be worth a lot of money to you.

Employee Stock Option Basics

With an employee stock option plan, you are offered the right to buy a specific number of shares of company stock, at a specified price called the grant price (also called the exercise price or strike price), within a specified number of years. 

Your options will have a vesting date and an expiration date. You cannot exercise your options before the vesting date or after the expiration date.

Your options are considered to be “in the money” when the current market price of the stock is greater than the grant price. 

Here’s a summary of the terminology you will see in your employee stock option plan:

  • Grant price/exercise price/strike price – the specified price at which your employee stock option plan says you can purchase the stock
  • Issue date – the date the option is given to you
  • Market price – the current price of the stock
  • Vesting date – the date you can exercise your options according to the terms of your employee stock option plan
  • Exercise date – the date you do exercise your options
  • Expiration date – the date by which you must exercise your options or they will expire

How They Work

To understand how a typical employee stock option plan works, let’s look at an example.

Assume on 1/1/2020 you are issued employee stock options that provide you the right to buy 1,000 shares of Widget at a price of $10.00 a share. You must do this by 1/1/2029. On Valentine’s Day in 2024 Widget stock reaches $20.00 a share and you decide to exercise your employee stock options:

  • Your grant price is $10.00 a share
  • The current market price is $20.00 a share
  • Your issue date is 1/1/2020
  • Your exercise date is 2/14/2024
  • Your expiration date is 1/1/2029

To exercise your stock options you must buy the shares for $10,000 (1,000 shares x $10.00 a share). There are a few ways you can do this:

  • Pay cash – you send $10,000 to the brokerage firm handling the options transaction and you receive 1,000 shares of Widget. You can keep the 1,000 shares or sell them.
  • Cashless exercise – You exercise your options and sell enough of the stock to cover the purchase price. The brokerage firm makes this happen simultaneously. You are left with 500 shares of Widget which you can either keep or sell.
  • Stock swap – You send in a certificate for 500 shares of Widget, which is equivalent to $10,000 at the current market price, and this is used to buy the 1,000 shares at $10.00 a share. You are left owning a total of 1,000 shares of Widget which you can either keep or sell.

Types of Options

There are two types of stock options companies issue to their employees:

  • NQs – Non-Qualified Stock Options
  • ISOs – Incentive Stock Options

Different tax rules apply to each type of option.   With non-qualified employee stock options, taxes are most often withheld from your proceeds at the time you exercise your options. This is not necessarily the case for incentive stock options. With proper tax planning, you can minimize the tax impact of exercising your options.

Your employee stock option plan will have a plan document that spells out the rules that apply to your options. Get a copy of this plan document and read it, or hire a financial planner that is familiar with these types of plans to assist you.

There are many factors to consider in deciding when to exercise your options. Investment risk, tax planning, and market volatility are a few of them, but the most important factor is your personal financial circumstances, which may be different than those of your co-worker.   Keep this in mind before following anyone’s advice.

Should You Keep the Stock?

Keeping too much company stock is considered risky.   When your income and a large portion of your net worth is all dependent on one company if something bad happens to the company your future financial security could be in jeopardy. Corporate executives need to consider this in their planning and work to diversify out of company stock.

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