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Here is a good explaination of stock options.

http://www.stockoptionsexplained.com/



Maybe you have read that an option is a right to buy something at a certain price at a certain point in the future. Maybe such a clinical definition didn’t get you any closer to understanding what stock options are all about. Any investor can get the concepts if they have stock options explained briefly and clearly to them. But please remember: understanding this game and winning at it are two very different things. Consult a licensed financial planner or broker before you make any moves. Buying stock options can lead to the loss of your entire investment. Also, stock options given to employees as part of a compensation package are a subject for another tutorial–I’ll explain puts and calls, buying stock options for one’s own portfolio. (I might cover writing or selling puts and calls in a future tutorial if there is enough interest)

To keep it simple I will cover only call options in this explanation, not puts-see this post to get put options explained. Calls give you the right to buy shares, while put options give you the right to sell shares, but just as I wouldn’t have to tell you how to do forearm curls with your left arm if I explained how to do them with your right arm, you will understand options mechanics–puts and calls–by simply understanding call option basics.

It is January 1 and the price of XYZ stock is $12 a share.

An options table tells me that an XYZ April 10 call option contract is trading at $3. If I owned this contract I would have the right to buy 100 shares of XYZ at a price (the premium) of $10, until the call expires on the third Friday of the expiration month, April in this case. One option contact gives me the right to buy 100 shares of the underlying stock.


Since the stock is at 12 it is easy to see why this right would have value: if I exercised my right and bought 100 shares at $10, I could immediately sell the shares for $1200, for a net profit of $200. The definable, guaranteed, intrinsic value, the difference between the $10 strike price and the current stock price, is concept #1. (In practice, options contracts are not exercised before their expiration, they are simply bought and sold until they are exercised by the final contract holder at expiration)

In our example, why is the option contract priced at three dollars? The intrinsic value of the contract is two dollars–the difference between the price at which I have the right to buy the shares at where the shares are priced right now. But there’s another critical part of the contract’s value.

It’s January 1, so there is more than 3 1/2 months left in the life of the contract, until the third Friday in April. The price of XYZ, the underlying stock, will fluctuate in that time; the potential for appreciation in the underlying stock means that the option contract has time value, ($1 in our example), in addition to the intrinsic value ($2 in our example). Intrinsic value is a matter of simple math, but the time value is determined by the market. When I refer to time value and intrinsic value remember that they are simply components of the premium price. An option contract has only one price but it is instructive to examine the two components of that price.

Let’s tweak our example above to make this a little clearer. What if XYZ’s stock price dropped from $12 to $9 per share the day after we bought our option? The option was $2 ‘in the money‘ at 12; now it’s $1 ‘out of the money‘. With the stock at $9, the option to buy the stock at $10 has zero intrinsic value: you can buy the stock at a lower price than owning the option currently allows you to do.

But does this mean that the option has zero value? It is now January 2 and your April 10 call still has more than 3 1/2 months until expiration. A lot can happen in that time. Naturally the market will ascribe a value to the April 10s that is more than zero, and in this case the value will be 100% time value.

For a given amount of time left before expiration, the closer the stock price is to an out-of-the-money option’s strike price, the greater the time value. Also obviously perhaps, for a given price, the more time left until the contract expires the greater the time value. I want to only cover stock options basics now, and so I won’t address myriad subtleties that affect the time value of options contracts, except to say that everything else being equal, the higher the underlying stock’s volatility (propensity to change over time) the greater the time value, as determined by the marketplace, will be.

The important thing to remember about time value is that (everything else being equal) it is “decaying” all the time, as time passes and the days until expiration decrease. Time decay is one of the things that makes options trading tricky. While you could theoretically hold a stock position indefinitely waiting for things to move in your favor, options do not afford you this luxury.

Leverage: More Bang For The Buck

Maybe you’re wondering why a person would buy stock options instead of just buying the stock. Great question.

Let’s say you’ve been watching XYZ, and you have reason to think it is a good buy at $12 a share. For $1200 you could buy 100 shares. For the same $1200 you could buy four of the XYZ April 10 calls, presently trading at $3 (4 X $300– each contract covers 100 shares of stock).

Let’s say the stock goes to $15. If you bought 100 shares your position is worth $1500, and you made 25% on your original $1200 investment, whether it takes three days or three years to move to $15 per share.

What if, with the stock at $12, you had bought four XYZ April 10 options instead? If XYZ stock goes to $15 per share, the difference between the $10 strike price and the current stock price is $5. We know that owning these contracts gives us the right to buy the stock at $10, and that with XYZ at $15 we can sell them for five dollars ($500) each, plus whatever time value is contained in the option, as determined by the marketplace. Our $1200 position is now worth $2000, plus time value. Even if it is the Friday afternoon of the third week in April and there is zero time value left, our profit is 67%.

This is an illustration of leverage, which allows you to control an asset using less money than it would take to buy the asset outright and therefore enjoy the benefits of an upward move in the price of an asset for less money. In this way, if your position is a profitable one, your percentage gain will be higher. The downside of leverage is that you can also be hurt more by a given move in the price of an asset, in terms of a percentage of what you invested. Central to any explanation of stock options basics is the double-edged sword of leverage.

Per our example, let’s say that the price of XYZ after we purchased it at $12 per share simply drifts down to $11 per share. This gives each of our options and intrinsic value of one dollar ($100), so our four XYZ April 10 options are worth a total of $400, plus time value. As we get closer to the end of the third week in April, the time value slowly decays to zero. If XYZ is at $11 per share at expiration our contracts are still in the money, but we have lost 67% of our original $1200 investment.

And what if the price of XYZ goes to nine dollars per share, and we hold on watching the time value decay to zero? At expiration there is neither intrinsic value because the contracts are out of the money, nor is there time value left. Our four options contracts expire worthless, and if we are human will probably wonder at least once or twice why we did not sell earlier, or why we didn’t buy the stock. Options explained easy doesn’t mean trading miracles guaranteed!

A final scenario regarding trading options vs purchasing stock: What if XYZ moved very little after we bought it, but we held on to our four options contracts while the stock drifted up a bit from $12, to maybe $12.50 by expiration in April? What is the value of our position? As the stock is 2.5 points over the strike price, the math is 4 x 2.50 or $250 = $1000. This position cost us $200, even though we were right about XYZ! We just weren’t right enough. Owning the stock would have us at a $50 profit, and we wouldn’t be obligated to exit.

With options, even simply buying puts and calls, you can see how the challenge is more complex than simply being right about the direction that a stock will move. It gets more complicated from here, but many strategies allow you to reduce risk by not focusing on simple leverage to profit, i.e. by selling options. Hedging with options is covered here.

Question time:

What is so special about $10 a share, April, and the 3rd Friday of each month for that matter? Nothing. Strike prices, options expiration months, and the 3rd Friday are all arbitrarily set by the options exchange. Regarding strike prices, if XYZ is at $12 per share you might see contracts with strike prices in increments of one dollar between five and 20, and $2.5 or $5 increments higher than that. As the stock goes higher or lower, new contracts are created to trade as needed.

Am I obligated to hold my option contract(s) until the expiration date? Absolutely not. You may sell at any time. Holding contracts until expiration is rarely the motive for buying options. In fact, because the time value of an option is usually decaying, you must constantly reassess whether you think the stock will move in your favor, and move fast enough, to outweigh the time decay that will occur in the contract over time (the ways in which volatility or lack of volatility can bloat or reduce time value of premiums is beyond the scope of this tutorial). Most people “trade” options for the short term and sell their contracts well before expiration, simply trying to capture the move they hoped would occur, to avoid the additional time decay in the premium. With options, you want not only to be right, you want to be right as soon as possible! ‘Buy and hold’ is usually not a strategy that works with options.

Having said that, you are entitled to hold your position until expiration day, at which time you are obligated to exercise your right to buy 100 shares of the underlying stock at the strike price. “Exercising your option” at expiry, which the final holder of an in-the-money option contract is required to do, will require additional funds to buy the shares of course, and you will have to pay commissions when you do sell later. The savings that you realize by buying shares at the strike price, which would be lower than the current stock price, can be had by selling your contracts immediately before expiration for just their intrinsic value (as all time value will be gone).

It may have only taken 10 minutes for you to have stock options explained to you. I hope I did a good job presenting stock options basics – the concepts, the potential rewards, and certainly the risks. I cannot emphasize strongly enough how hard it is to consistently make money by going long stock options. I’ve certainly heard estimates of more than 90% of put and call trades losing money. Writing or selling covered options, which is the other side of the more risky long call or put position, is a stock option explanation for another day and if there’s enough interest I might cover writing options in another tutorial.

Posted by admin under Stock Options Explained In Five Minutes 7 Comments »

Selling Options Guide

Many investors have never even heard of stock options selling. For most people options trading is synonymous with risk and potential big profits or losses, using leverage by buying options. However, a lot of savvy investors use strategies involving selling options, also known as options writing, to hedge existing positions against the possibility that the stocks that they already own, or are short, will move against them.

Now hedging with options is nowhere near as exciting as leveraging with options and doubling or tripling your money quickly. Perhaps this is the reason you don’t get the details of options selling explained as frequently in books or on websites on stock options basics. It certainly is a lot more exciting than losing all the money that you have put into a long option position though, which happens all too often unfortunately!

By writing puts and calls you can benefit from the fact that the great majority of long put and call positions, i.e. where put/call contracts are bought, are losing bets for the buyers. When an investor engages in writing options, he attempts to make money in a way that is exactly the opposite of buying options. In a nutshell, the options seller takes the other side of the buyer’s much riskier position. In this way he has a corresponding likelihood of profiting. The risk, as well as the potential gain, is smaller. However, the potential for gain is greater, and many good investors will take consistent gains over a mix of big wins and frequent losses of an entire position.

Example time. I will talk here about writing calls against stock that you own. The mechanics are the same if you write puts against stock that you are short, only the directional movements are reversed for writing puts.


It is April and you own 100 shares of ABC, which is trading at the moment at $33 per share. You feel good because you were right about the stock, having bought at $25. You don’t think it’s done moving up though, and you have no intention of selling at $33. At the same time you recognize that a pullback or some consolidation might be in order, and you would appreciate a way to reap some of the benefit from this position without actually selling your shares. You can sell one ABC August 35 call, at $1.50, let’s say. You are selling someone the right to buy 100 shares of ABC at 35 by the end of the third week in August, and for this you are paid $150 in this case ($1.50 X the 100 shares that the contract represents).

The person on the other side of the transaction, the call buyer, has paid a relatively small amount of money for an out-of-the-money option that may very well expire worthless, in the hope that the stock will continue its upward rise and give him a very high percentage gain. In addition to the possibility that the option will become in-the-money and have intrinsic value, he also would benefit by having the stock move as soon as possible so that he may sell before time decay hurts the value of his option too much.

As the option seller you accept an amount that is small relative to the size of your position ($3300 at the moment), but it functions as a small insurance policy protecting you in case the stock does have a pullback from $33, temporary or otherwise. The $150 premium you receive lowers the cost basis of the position for you. You bought at $25, but now this position has cost you $23.5, or $2350.

If the stock is below $35 per share on expiration day, roughly 4 months from now in August, you keep your ABC stock as well as the premium amount. Over the four months that premium represents approximately a 13% annualized return (150*(12/4)/3300=~13%).

What if the stock price is above the strike price on expiration day? Well, you must deliver 100 shares of ABC at $35 per share. Having bought the stock at 25, you are still pretty happy, but the critical thing to recognize is that if the stock keeps going past $35 a share you would have missed out on any move above $35 directly because of the insurance that you purchased to guard against a drop back in the price of the shares. Still, another thing in your favor is also the premium amount that you get to keep.

Note the clean inverse relationship between the motivations of the options buyer and option seller, and the ways in which each stands to benefit.

The option seller wants to hedge and is happy with a small return relative to the size of his existing position. Time decay is his friend; all else being equal, the price of closing his position before expiration goes down each day, until expiration when the option expires worthless (if it’s out of the money) and he keeps 100% of the premium and his shares, or (if the option is in the money) is forced to sell his shares at a gain while still keeping the premium he received.

The options buyer uses leverage for a possible large percentage return. The passage of time will work against the value of his position (notwithstanding volatility and other factors beyond the scope of this article).

That is the basics of stock options selling explained. If you do your homework you might find that writing covered options gives you a fairly good shot at making relatively small but consistent gains over time.

Why do I say “covered” options? What are covered calls and puts and why the qualification?

A covered call writer owns 100 shares of the underlying security against which the call is written, for each call that he has written. (A covered put seller is short 100 shares of the underlying security for each put he writes) You could establish a covered options position by selling a call or put contract against a stock position (long or short, respectively) that you already have established, as in our example, or you could buy or short shares at the same time as you write an option against them.

Writing uncovered or naked options means that you do not own the underlying shares, if you are writing calls, or you are not short the underlying shares if you are writing puts. At expiration you would be required to

So what’s the big deal about naked puts and calls? In a word, risk. There is a huge difference between selling “covered” options versus selling “uncovered” or “naked” options, in terms of risk between the two.

As a call option contract gives you the right to buy 100 shares (or for puts, to sell 100 shares) of the underlying security at a given price on a given date in the future, there must be a place from which these shares are delivered (or a counterparty who will buy the shares, for puts) if the option is in-the-money on expiration day.

As the options writer or seller, you have been paid an amount of money, a premium, to assume that responsibility. If the option is exercised and you do not already have the shares in your account as a call seller (or if you are not already short the shares as a put seller), delivery of 100 shares for every call contract that you have written (or purchase of 100 shares for each put you wrote) would be a relatively large, immediate expense to you.

But the real problem here, for a naked call position that goes against you, is that you would be forced to purchase shares at the current market price and sell them immediately at the strike price, which would be below (and maybe far below!) the current price of the stock in the case of an in-the-money call. For a naked put position whose strike price is higher than the stock price by expiration day, you would have to buy 100 shares for each contract that you have written, at a higher price at which you can currently buy the stock.

For calls, you would immediately lose the difference between the strike price and the price at which you may currently buy the shares in order to fulfill your obligation to deliver. For a naked put position that goes against you, you must buy the stock that the put buyer owns the right to sell (a terrible sentence I know; I hope it makes sense).

This is one case where writing naked puts and naked calls have different outcomes if the trade goes against you: when your naked put position concludes at a loss it is only a paper loss. Buying the shares at the strike, higher than the current market price, leaves you with those shares. With naked calls, immediate delivery equals an immediate loss.

Either way, if you have many contracts this could add up to a lot of money, especially when compared to the relatively small amount that you received for writing the options. Brokerage firms will require that you have money enough in your account to cover (literally) naked options positions that go against you, in lieu of owning the shares. There is a possibility that even a option contract that was far out-of-the money when you wrote it could expire in-the-money. You must show a way to address this possibility, whether through cash in your account, equity, or by simply owning (or having short) shares of the underlying stock equal to the shares represented by the contract(s) that you have written (i.e. covered puts or calls).

To circle back a little, hopefully you can see clearly now why writing covered puts, against shares that we are short, keeps us safe from a downturn: if we are forced to buy shares at the strike price at expiration, we are simply covering an existing short position at a profit. It’s the inverse outcome of a covered call position where the stock price rockets higher. We have lost only the opportunity cost of missing the big move, in return for the insurance of the call, or put, that we would have been better off not writing. Having naked options positions go against us leaves us facing a very different type of music, though maybe slightly less dire in the case of naked puts, as we can theoretically hold our newly purchased stock until it comes back…

So to recap, an options seller normally trades away the prospect of benefiting if his underlying long or short position runs far in his favor, i.e. beyond the strike price of the option he writes. In return he receives the premium from the options buyer, which can be though of as insurance against a the stock moving against him (as it reduces his cost basis), and a simple windfall if the stock trades sideways. Keeping the proceeds from these premium amounts if positions work out in your favor can give you very respectable gains, though really never triple-digit home runs as can happen with long option positions. Sometimes sophisticated investors establish naked options positions, but they are quite speculative and require sophistication and financial wherewithal.

In the real world, writing options is especially well-suited to investors with large portfolios who would like to protect paper gains that they might have, or reduce their cost basis when they open up a position. The benefits of selling options must always be weighed against the fact that they reduce the potential profit of a given long or short stock position. Sometimes letting a stock continue to move in your favor with a trailing stop is a good way to have a nice gain turn into a huge gain, even without leverage. Capping a position’s potential gains by selling an option against it is probably not a strategy you should use for every single stock that you buy or short. There are many strategies one may use with covered options; another good one is writing naked puts to buy a stock lower than its current price, or simply pocket the premium if it never gets there before expiration.

Even though writing options (at least covered options) is safer than buying options, it’s not for everyone. Having stock options explained to to you properly, as I hope I’ve done, does not reduce the risk of trading them. Please consult a financial professional before investing in them.