Puts and Calls: A Basic Options Primer
The Basics Calls: A call is the right to buy stock for a certain, predetermined price.
This right exists up until a specified expiration date, at which point the right to buy is forfeited.
Puts: A put is the right to sell stock at a certain, predetermined price.
This right exists up until a specified expiration date, at which point the right to sell is forfeited.
How does it work? An option is a contract between two parties, the buyer and the seller (or writer) or the option.
The buyer is purchasing the right to buy or sell stock at the predetermined price within the timeframe specified in the contract.
The seller is giving the buyer the right to buy stock from the seller, or sell stock to the seller at the specified price.
Should the buyer CHOOSE to exercise his right, it is the OBLIGATION of the option seller to fulfill that request.
The buyer has no obligations to the seller.
So in each contract, the buyer has the OPTION to exercise, and the seller has the OBLIGATION to fulfill the request, if the buyer chooses to exercise.
Example: Jack Sells ABC 100 Call to Jill Consider the case of stock ABC, trading at $100.
Jack sells a $110 call (the right to buy stock for the price of $110) to Jill.
Jill now has the right to purchase ABC stock from Jack, for the price of $110.
Jill, obviously would not choose to exercise this right today, as she could easily buy ABC stock from the marketplace for $100, instead.
However, if tomorrow, the price of ABC shoots up to $120, Jill may choose to exercise her RIGHT to buy ABC for $110.
Doing so, Jill would be effectively buying ABC stock at a $10 discount to the market.
We would say that ABC is "Ten dollars in the money.
"Consider it a $10 off coupon for ABC stock.
One strategy for Jill would be to then exercise her right to buy ABC for $110, and simultaneously sell stock in the marketplace for $120.
This would effectively net Jill a $10 profit per share of stock and option that she traded.
(Actually, any option you buy on an exchange has a "100 multiplier".
It is good for 100 shares of stock -- so an option that finished in-the-money by $10 would allow you to make $10 on 100 shares of stock, or $1000, not just $10) Jack (the seller of the option), on the other hand would have the OBLIGATION to sell Jill ABC stock at the price of $110 dollars, $10 LESS than he could sell it in the marketplace.
This represents, in terms of opportunity cost, a $10 loss to Jack.
This potential risk that Jack assumes when selling the option to Jill is the reason why Jill must pay Jack for the option.
If the price of ABC stock were to go down to $90 and stay there past the predetermined expiration date of the option, Jack would pocket the amount of money that he sold the option for.
This amount is the "premium" of the option.
Summary: When option sellers sell options, they assume a risk that they will be required to fulfill the obligation of the contract at a loss.
For this risk, they receive the premium (price) of the option from the buyer.
When option buyers buy options, they acquire the potential to make money if the underlying stock moves in the direction they predict.
If it does so, they stand to potentially gain the difference between the exercise price and the stock value at a later date.
For this potential reward, they must pay the seller of the option the premium (price).
If the option expires worthless, the buyer will have lost the premium.
Time Value Would you pay more money for the option to buy MSFT for 25 dollars any time in the next 24 hours, or anytime in the next 10 years?10 years, of course, because there is a greater likelihood that MSFT will trade at a MUCH higher price in the next 10 years, than in the next 24 hours.
Increasing the duration of the contract (the time to expiration) increases the value of an option.
Similarly, the right to sell MSFT at $15 by tomorrow is worth less than the right to sell MSFT at $15 within the next 10 years because there is a greater likelihood that MSFT will trade at a price less than $15 in the next 10 years.
From the perspective of the seller, there is a greater RISK that long term options will finish in-the-money.
This greater risk requires them to demand a greater reward, in the form of higher premium.
For the buyer then, there is an inherent tradeoff between price and reward potential.
If Jill had an inclination that ABC stock will decrease in value, she may choose to buy a put.
As the value of ABC plummets, she would be able to sell ABC at a price higher than market value, while simultaneously buying it for market price, making the difference in the exchange traded price and the strike price indicated in the option.
The tradeoff occurs when determining what timeframe she would like to have this option for.
For the right to exercise this option over a longer period of time, she would have to pay a larger sum of money, eating in to her profit potential.
However, if she chooses too short a timeframe, her option may expire before she is able to profitably exercise it.
Risk and Reward What risks and rewards do option buyers and sellers (writers) incur? The risks are the potential losses; these are balanced by the rewards, or potential gains.
A buyer of a call pays the option premium.
If the option expires worthless, the buyer will los this premium to the seller.
The premium is the maximum cash value the buyer can lose.
However, the possible gain is technically unlimited.
If the stock goes up in value, the buyer of the option can exercise his right to buy for the strike price, while selling stock at market price.
Since the stock can go infinitely high, there is no cap in the difference between stock price and strike price.
A buyer of a put has a similar risk profile: at most, she loses only the premium.
At most, in the event that the stock value goes to $0 (the company goes bankrupt and loses all value), she will be able to sell the stock to the other party (whoever sold her the option) for the strike price.
Buy the same reasoning, writers of options stand to lose large quantities of money and only stand to gain the premium.
When the buyer wins, the seller loses and vice versa.
Summary:
Buyers of options have limited risk with unlimited profits.
Seems sort of unfair doesn't it?However, that isn't to encourage anyone to be only a buyer of options.
Large price moves in the underlying are rarer than small price moves, and with small price moves, the sellers of options are more frequently the winners.
Option pricing is calculated based on the expected value, so over time and many transactions, buyers and sellers should break even.
However, the expected values evens out only over the long-term, so it is imperative that the investor has the ability to withstand short-term gains and losses.
This post is part two in a three-part series on investing using options: part 1 | part 2 | part 3
This right exists up until a specified expiration date, at which point the right to buy is forfeited.
Puts: A put is the right to sell stock at a certain, predetermined price.
This right exists up until a specified expiration date, at which point the right to sell is forfeited.
How does it work? An option is a contract between two parties, the buyer and the seller (or writer) or the option.
The buyer is purchasing the right to buy or sell stock at the predetermined price within the timeframe specified in the contract.
The seller is giving the buyer the right to buy stock from the seller, or sell stock to the seller at the specified price.
Should the buyer CHOOSE to exercise his right, it is the OBLIGATION of the option seller to fulfill that request.
The buyer has no obligations to the seller.
So in each contract, the buyer has the OPTION to exercise, and the seller has the OBLIGATION to fulfill the request, if the buyer chooses to exercise.
Example: Jack Sells ABC 100 Call to Jill Consider the case of stock ABC, trading at $100.
Jack sells a $110 call (the right to buy stock for the price of $110) to Jill.
Jill now has the right to purchase ABC stock from Jack, for the price of $110.
Jill, obviously would not choose to exercise this right today, as she could easily buy ABC stock from the marketplace for $100, instead.
However, if tomorrow, the price of ABC shoots up to $120, Jill may choose to exercise her RIGHT to buy ABC for $110.
Doing so, Jill would be effectively buying ABC stock at a $10 discount to the market.
We would say that ABC is "Ten dollars in the money.
"Consider it a $10 off coupon for ABC stock.
One strategy for Jill would be to then exercise her right to buy ABC for $110, and simultaneously sell stock in the marketplace for $120.
This would effectively net Jill a $10 profit per share of stock and option that she traded.
(Actually, any option you buy on an exchange has a "100 multiplier".
It is good for 100 shares of stock -- so an option that finished in-the-money by $10 would allow you to make $10 on 100 shares of stock, or $1000, not just $10) Jack (the seller of the option), on the other hand would have the OBLIGATION to sell Jill ABC stock at the price of $110 dollars, $10 LESS than he could sell it in the marketplace.
This represents, in terms of opportunity cost, a $10 loss to Jack.
This potential risk that Jack assumes when selling the option to Jill is the reason why Jill must pay Jack for the option.
If the price of ABC stock were to go down to $90 and stay there past the predetermined expiration date of the option, Jack would pocket the amount of money that he sold the option for.
This amount is the "premium" of the option.
Summary: When option sellers sell options, they assume a risk that they will be required to fulfill the obligation of the contract at a loss.
For this risk, they receive the premium (price) of the option from the buyer.
When option buyers buy options, they acquire the potential to make money if the underlying stock moves in the direction they predict.
If it does so, they stand to potentially gain the difference between the exercise price and the stock value at a later date.
For this potential reward, they must pay the seller of the option the premium (price).
If the option expires worthless, the buyer will have lost the premium.
Time Value Would you pay more money for the option to buy MSFT for 25 dollars any time in the next 24 hours, or anytime in the next 10 years?10 years, of course, because there is a greater likelihood that MSFT will trade at a MUCH higher price in the next 10 years, than in the next 24 hours.
Increasing the duration of the contract (the time to expiration) increases the value of an option.
Similarly, the right to sell MSFT at $15 by tomorrow is worth less than the right to sell MSFT at $15 within the next 10 years because there is a greater likelihood that MSFT will trade at a price less than $15 in the next 10 years.
From the perspective of the seller, there is a greater RISK that long term options will finish in-the-money.
This greater risk requires them to demand a greater reward, in the form of higher premium.
For the buyer then, there is an inherent tradeoff between price and reward potential.
If Jill had an inclination that ABC stock will decrease in value, she may choose to buy a put.
As the value of ABC plummets, she would be able to sell ABC at a price higher than market value, while simultaneously buying it for market price, making the difference in the exchange traded price and the strike price indicated in the option.
The tradeoff occurs when determining what timeframe she would like to have this option for.
For the right to exercise this option over a longer period of time, she would have to pay a larger sum of money, eating in to her profit potential.
However, if she chooses too short a timeframe, her option may expire before she is able to profitably exercise it.
Risk and Reward What risks and rewards do option buyers and sellers (writers) incur? The risks are the potential losses; these are balanced by the rewards, or potential gains.
A buyer of a call pays the option premium.
If the option expires worthless, the buyer will los this premium to the seller.
The premium is the maximum cash value the buyer can lose.
However, the possible gain is technically unlimited.
If the stock goes up in value, the buyer of the option can exercise his right to buy for the strike price, while selling stock at market price.
Since the stock can go infinitely high, there is no cap in the difference between stock price and strike price.
A buyer of a put has a similar risk profile: at most, she loses only the premium.
At most, in the event that the stock value goes to $0 (the company goes bankrupt and loses all value), she will be able to sell the stock to the other party (whoever sold her the option) for the strike price.
Buy the same reasoning, writers of options stand to lose large quantities of money and only stand to gain the premium.
When the buyer wins, the seller loses and vice versa.
Summary:
- Buy Put: Make money when the market goes down.
Limited loss potential = cost of option.
Much larger profit potential = Strike price minus value of stock. - Buy Call: Make money when market goes up.
Limited loss potential = cost of option.
Unlimited profit potential = value of stock at later date minus strike price. - Sell Put: Make money when the market goes up.
Limited profit potential = cost of option.
Much larger loss potential = Strike price minus value of stock. - Sell Call: Make money when market goes down.
Limited profit potential = cost of option.
Unlimited loss potential = value of stock at later date minus strike price.
Buyers of options have limited risk with unlimited profits.
Seems sort of unfair doesn't it?However, that isn't to encourage anyone to be only a buyer of options.
Large price moves in the underlying are rarer than small price moves, and with small price moves, the sellers of options are more frequently the winners.
Option pricing is calculated based on the expected value, so over time and many transactions, buyers and sellers should break even.
However, the expected values evens out only over the long-term, so it is imperative that the investor has the ability to withstand short-term gains and losses.
This post is part two in a three-part series on investing using options: part 1 | part 2 | part 3