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What are stock Options? Definition and Trading Part I

This is a multipart article series on stock options starting with terms and basic call option buying examples.

Part I includes simple stock option terms and buying call options.

Part II includes buying put options for portfolio insurance protection and getting a discount on buying stocks.

Part III includes more complex stock option definitions and terms, writing covered calls.

Part IV includes writing uncovered calls to short a stock with lower risk.

Part V includes strategies using options for dividend capture.

Part VI includes using complex option strategies like straddles.

Part VII includes more advanced option strategies and special situation option trading.

When reading about or talking about stock options, one of two types is usually the focus. The first type is stock options for employees as part of an employment benefit package. After receiving employment options, they work much the same as the second meaning of options, but often with greater restrictions on how soon they may be exercised. My focus in this article will be on stock options that trade publicly and are used as investment and hedging vehicles.

A stock option conveys rights from a seller to a buyer. There are two types of stock options.

Let’s go over some stock option terms and option definitions first. I will explain further what each means after.

Call option buyer = the right without obligation to buy an agreed upon stock at a set price within an agreed upon time period

Counterparty = the entity on the other side of the trade. If you are a buyer of an option, the counterparty is the seller. If you are the seller, the counterparty is the buyer. The counterparty for American exchange traded options is the OCC.

Exercise / Exercising = the act of the buyer telling the counterparty they want to either buy the stock at the strike price (in cases of call options), or sell the stock to the counterparty (in the case of put options)

Expiration date = the date the stock option no longer has any value. For monthly and longer dated options the expiration date is the third Saturday of the expiration month. For this article we will use the FRIDAY before expiration day (Saturday) as the expiration date to keep things simple*.

Equity option = same thing as stock option. In this article equity option and stock option will mean the same thing. The term “stock” is the common use term for equity.

Long = means to own or buying a security, it could be a stock or an option. Long is the opposite of “short”. “I am long P2T” means I own P2T (could be stock, options, or any type of security). To be long means to be bullish on the security.

Multiple = the number of shares one options contract is for. Generally (unless stated otherwise), all stock options are for one hundred shares of stock. As a result, the multiple will be usually considered 100 (100 * number of contracts = number of shares) Knowing the multiple is useful when calculating total price. Events like stock splits can alter the multiple so it’s always a good idea to make sure of the status.

OCC (Options Clearing Corporation) = founded in 1973, provides clearing and settlement services for stock option exchanges.

Options Exchange = physical places public buyers and sellers are able to buy and sell stock options

Premium (option premium) = the money paid from the buyer of the option to the seller of the option as consideration for writing the option.

Put option buyer = has the right without obligation to sell an agreed upon stock at an agreed upon price, within an agreed upon time period

Short = means to sell or already have sold something you do not already own. Short is the opposite of “Long”. “I am short P2T options” means the same as “I wrote P2T options that I did not already own, I am the writer of the options”. To be short is to be bearish on the security.

Strike price = also known as the exercise price, the price the stock will be traded for.

Writer (option writer) = the seller of the option contract. Selling and writing mean the same thing in this article.

Ok, now that we have the basic terms of stock options covered, and you now know what they mean. Yes, there are many more terms and concepts you will need to know before actually making an educated trade and you can read more about advanced option related concepts here at paid 2 trade. Let’s go on to an actual trade and see if this makes sense so far. Let’s assume you want to BUY a CALL option based on the company P2T (not a real company). Here are the details and we will not include commissions in this example:

P2T trades at $100 per share currently. You believe P2T earnings and revenue will grow quickly and the stock price will move higher in the next month. You believe P2T will likely trade for $120 more on or before the third Friday of next month, which happens to be the month of May. You look at the option pricing and see you can buy a CALL option for P2T with a STRIKE PRICE of $110 and an EXPIRATION DATE of May 20th for a premium of $0.75. You decide to buy it.

This will give you the RIGHT (no obligation), to buy 100 shares of P2T for $110 a share and will cost you $75 to buy ONE stock option (remember the multiple) ANY time up to May 20th**. Of course you can sell the option before the option expiration date resulting in a gain or less depending on how much P2T stock moves up and down and the timing of the moves, but if you hold on to the option until option expiration day, and P2T is trading for OVER $110 a share (for example $115) you may exercise the option and buy P2T stock for $110 a share even though it’s trading for $115. You could then sell P2T for $115 and make a profit of $4.25 per share ($115 - $0.75 cost of the option), for a total gain of $425.

On the other hand if P2T moves higher, but not enough, for example from the current price of $100 up to $109.99, on the day of expiration, the option will expire worthless and you would be out the $75 premium paid per option contract.

If P2T moves lower the option will expire worthless as well.  Any price below and including $110.00 leaves the option buyer without any money from the trade.

If P2T does move higher and is trading at $110.75 on option expiration day, the option buyer can exercise the option for the strike price of $110 and turn around and sell the stock for $110.75 and break even on the trade (minus commissions and fees).

The goal as we can see from the CALL OPTION buyers point of view is to buy calls that are currently underpriced relative to the future price of the stock, and the goal of the option seller/writer is to sell call options that are overpriced relative to the future price of the stock. Since the average trader cannot know for sure what the price of a stock will be at a future date, we use mathematical formulas to try to calculate the probabilities or odds of a stock moving from the current price to or further beyond any given strike price. One of the famous option pricing calculators is the Black-Scholes option pricing formula which is good enough for buyers wanting to get an idea for where the options “should” be trading for. It’s good enough for buyers because it slightly underestimates the odds of the option finishing in the money***. While option pricing calculators are helpful, the actual prices of options are based on supply and demand. As you review option pricing in the real world, you will quickly see option pricing can move significantly away from what the calculator indicates the theoretical value to be.

An option buyer doesn’t need to exercise an option before the option expiration date to make (or lose) money right away. Options can go up or down in price immediately based on several factors, including the time remaining to expiration, and the price of the stock. If PT2 jumps up $20 to trade at $120 the day after you buy a $110 call option, your call option will be worth at least $10 ($120 - $110 strike price) and instead of exercising the option you simply sell the option on the market for at least $10 and likely more. As a result, a buyer of a call option can profit from the rise in a stock price in the next week, even though the option does not expire for a month or more.

If you have any questions or feedback please feel free to use the comments section below.

In my next article we will go over what PUT OPTIONS are, put option definitions, and how they can be used to either protect your investment like insurance or to buy a stock for less than the current trading price.

 

* The last day stock options may be exchange traded is the third FRIDAY of the month (the day before expiration), and the last day to exercise an option is also the third FRIDAY of the expiration month, currently two hours or less (OCC cutoff time is 5pm CST) after the regular stock trading day has finished (3pm CST), but before after-hours trading is complete. ETFs like the S&P 500 (ARCA:SPY) options trade under slightly different rules.

** American style options may be exercised any time during the option life, while European style options are only able to be exercised on the expiration date. Generally, non dividend stock options only get exercised during option expiration day.

***. Professional writers / sellers use a much more complicated model to include differences in risk depending on the type of option (call vs put) and fat tail / “black swan” events happening more often than “normal” (which seems to be the case more often than many models predict). Other limitations of Black-Scholes include the assumption of continuous trading and not accounting for trading halts.

The picture is a trading pit at the Chicago Board Option Exchange owned by CBOE Holdings Inc. (CBOE) in Chicago IL., the largest option exchange in America. Many of the options I trade are bought and sold here.

 

Option trading involves risk and is not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation (OCC), One North Wacker Drive, Suite 500, Chicago, Illinois 60606. The information on this website is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions which should be referred to for additional detail and are subject to changes that may not be reflected in the website information. No statement within the website should be construed as a recommendation to buy or sell a security or to provide investment advice.

Robert Weinstein Google+

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