Understanding Options: Calls and Puts

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2 2 Understanding Options: Calls and Puts Important: in their simplest forms, options trades sound like, and are, very high risk investments. If reading about options makes you think they are too risky for you, don t worry that s very healthy! We never recommend buying or selling options except as part of well considered strategies, but before options strategies start to make sense, you first need to understand the basics of calls and puts. It never hurts to have options, according to the old aphorism, and in the stock market, the very same thing is true. Options are very much what they sound like: the ability, but not the requirement, to choose to do a particular thing. In the case of stock options, that thing is buying or selling a particular stock at a particular price. To illustrate how options work, let us consider a fictional company, United Fruitcake Outlet (UFO). It is January 1 and UFO is trading at $100 per share. Buyer Bartholomew, who we ll call B, and Seller Sam, who we ll call S, are both bullish on the stock, but in different ways. B believes UFO will certainly double in price in the next 6 months, and S believes UFO will rise, but certainly not by more than 10%. The market offers both B and S the ability to maximize the money they can make if their assumptions are correct: B buys from S the option to buy 100 shares of UFO at the price of $125 at any time before July 1. (One stock option typically covers 100 shares, so this is realistic.) B is willing to pay 5 dollars per share ($500 total) for the option, which S is happy to receive. You can think of the option as a contractual agreement between B and S that makes sense for both of them, given their outlook on UFO. Consider the deal from B s perspective. He pays $500 up front. If he is wrong, and UFO doesn t rise above $125 per share before July 1, his entire investment of $500 will be lost. But consider what happens if he is right: if UFO does to go 200 within the next 6 months,

3 Understanding Options: Calls and Puts 3 he still has the right to buy shares at $125, so he buys the 100 shares from S for a total of $12,500. On the very same day, he can, if he chooses, sell all his newly acquired shares of UFO on the open market for $200 each, or $20,000. Since he must pay $12,500 for the stock, and he has already paid $500 for options, his total expenses are $13,000, and his net profit is $7,000 not a bad return on a $500 investment. If you look at his return on a per share basis, he paid $5 dollars per share for the right to buy the stock at $125, so his adjusted buy-price for each share is $130. Upon selling his shares for $200 per share, he pockets a profit of $70 per share. Now consider the same deal from S s perspective. He receives $500 up front. That money is his to keep, and as long as UFO doesn t rise above $125 per share before July 1, it will be pure profit. But suppose UFO does rise above $125 per share. If, on July 1, UFO is

4 4 Understanding Options: Calls and Puts trading at $200 per share, B can insist on buying 100 shares from S at $125 per share. In the unfortunate event that S doesn t actually own the stock, he is obliged to buy it from the market at its current market price of $200 per share so that he can sell it to B for $125 per share for an immediate loss of $75 per share, mitigated only slightly by the initial payment he received of $5 per share, making his per share loss $70. That s pretty bad, but for S, it could always have been worse, and that is the most unenviable thing about S s position: for every dollar above $125 that UFO rises, he will, in effect, be losing $100, and because there is no limit to how high UFO could theoretically rise, there is no limit to how much money S could lose. Here I must repeat that both B and S have made a market move that carries enormous risk: for B, there is the very high likelihood of losing his principal, and for S, there is the possibility of unlimited loss. The options trades described above should never be used by themselves, but always as part of a well considered strategy. The above is an example of a call option, because the buyer of the option has the ability to buy the stock, or call it away from the seller, at a particular price. A put option works exactly the same way, except that the buyer of the option has the ability to sell a stock to, or put it on the seller at a particular price. Let s say it is January 1 again, UFO is trading at $100, but B and S are both bearish on the stock instead of bullish. B thinks UFO will fall below $50 and S is convinced it will not fall below $90, so B buys the right to sell 100 shares of UFO to S at $75 per share, any time before July 1, for $500. Again, S

5 Understanding Options: Calls and Puts 5 immediately receives cash, and if the stock goes nowhere, goes up, or even falls, but not to $75 or lower, the money is pure profit. If, on the other hand, UFO does fall below $75, say to $50 per share, B can buy 1000 shares of the stock for $50 per share on the open market, and then, on the same day, force S to pay $75 per share for them. Because B already paid S $5 per share, his cost adjusted profit is $20 per share, or $2,000. S, in this case, ends up buying stock for $75 per share that is only worth $50 per share. If he sells, he will incur an immediate $25 per share loss, minus the $5 per share he was initially paid, for a net loss of $20 per share, or $2,000 in this case. Again, both B and S have made a market move that carries enormous risk. B again faces the likelihood of losing his principal, and S faces a potential loss of up to $7,000. He cannot lose more than that, in this case, because the stock cannot go any lower than zero, but consider that his potential loss is higher than his potential profit by a factor of 14. You may wonder where the numbers 125 and 75 came from in the above examples. These were the prices at which B had the option of buying or selling the stock. In options trading, this is referred to as the strike price, and the answer is that they could, in theory, have been anything. It may help to recall the analogy of an option as a contractual obligation. Two parties may, within the bounds of practicality and feasibility, agree to any such arrangement. Thus, in our first example, B could have bought the option to buy shares of UFO from S at a strike price of $125, or $100, or $200, as long as both B and

6 6 Understanding Options: Calls and Puts S agreed on the strike price. The same is true of the expiration date of July 1 used in the examples above. B and S could agree, theoretically, to form a contractual bond for any length of time, as long as the time period was agreed upon by both parties. Now, in practical terms, only certain options trades are actually available. For most stocks, options are available at strike price intervals of $5, though some lower priced stocks have options available at intervals of $2.50 or even $1.00. Options are also available in monthly intervals, though not all months are available for all stocks. As for the price paid for the options, ($5 per share in the above examples) that too is, in theory, determined by the agreement of the parties involved, which leads to a very important point: options, like stocks, trade on the open market, and the market, comprising real people, can value them as it chooses, taking anything and everything into consideration. In practical terms however, the value of an option depends on two things: intrinsic value and time value. Intrinsic value can be determined easily. When a call option s strike price is below the price of a stock, the option can be exercised for an immediate per share profit of the difference between the strike price and the stock price. The same is true when a put option s strike price is above the price of the stock. Such options are said to be in the money. In our first example, B s call option had a strike price of 125, and the stock went to $200. The option was then $75 per share in the money. An option that is in the money will never trade for less than the amount by which it is in the money, so B s option to buy 100 shares had an intrinsic value of $7,500. It would likely have been worth somewhat more than that, however, as it also had time value. Time value, unlike intrinsic value, cannot be mathematically determined, as it is based on the market s level of confidence that an option will go into the money (or deeper into the money) before the option expires. Consider our first example again. When B buys the call option for $5 dollars per share, the option has a strike price of $125 and the stock is trading for $100. The option has no intrinsic value, since exercising them would mean paying $125 per share for a stock that can be bought or sold on the market for $100 per share. It is $25 out of the money, but because there are six months before expiration, and because they might go into the money within that time, they have a definite value, though not an easily quantifiable one. The $5 per share price is determined based on market forces. If optimism were high, say because a larger company was thinking of buying UFO out, the same option, with the same strike price and expiration date, might well have cost twice as much. If optimism were low, say because of impending litigation, B might have been able to buy the option for much less. The time value of an option that is out of the money depends on the amount of time before its expiration and the perceived chance that it will go into the money. Keep in mind that unless it is about to expire, an option that is in-the-money still has a time value in

7 Understanding Options: Calls and Puts 7 addition to intrinsic value, because it could always go deeper into the money. In this case, the time value is also called the premium, as it is value above the option s intrinsic value. Now you know about calls and puts, and the good news is, all options are calls or puts. Of course, merely knowing how calls and puts work is like knowing the rules of a game but not the strategy. Be sure you fully understand any options strategy that you undertake. Options can provide you with ways to maximize your profits and minimize your risks in the market, just remember to play safe. If you ve followed me this far, why not follow a little further? Let me show you what InvestorsObserver.com can do for you. Learn More > 413-A East Main Street Charlottesville, Virginia (434) [email protected] We may be reached by phone at or Investing in stocks, bonds, options and other financial instruments involve risks and may not be suitable for everyone. Visit our website for complete disclaimers, warnings and disclosures.