More about Options – Lesson 3

Options are contracts between individuals. Even though you go through a broker to purchase an options contract, behind the scenes the contract is between you and another person.

In order for you to purchase an option someone has to be willing to sell it to you.

Why would someone be willing to give you the opportunity to purchase stock at a known price for a period of time? Especially when no one knows what the price of the stock may do between now and expiration. The stock could soar and the seller of the option would have to make good on the contract at a loss.

The reason people sell options is pretty much the same reason people buy them. They are speculating that the underlying asset is going to move in their favor or not move at all before the expiration date.

You, as a buyer pay a premium for the option. The seller gets this premium credited to his or her account and if the contract expires worthless, the seller keeps the premium.

Let’s show an example from both sides.

First as a buyer.

ACME Industries is trading at $40 today. You think that it’s undervalued and will increase in price before the expiration date next month.

You check the options price tables and notice that you can purchase a $40 strike contract for next month’s expiry for $2. This means you would pay a premium of $2 over today’s closing price.

You think this is a good deal so you purchase one contract with an expiry three weeks out for a $40 strike price for $2 per share. Remember option contracts are traded in multiples of 100 shares so the premium you paid is $200. This goes straight into the account of the seller never to be seen again.

You could have bought the stock today for $40, but you decided to pay the premium to have the option instead.

Now you can see that you’ve actually paid more for the option to buy the stock than you would have if you had purchased the stock outright.

Consequently, the stock would have to increase in price to $42 to hit your breakeven point. If the stock does not increase in price above $42 before the expiration date there is no point in exercising your option and the contact would expire worthless.

This is the premium you pay to have the option to buy the stock at $40 for three weeks.

The purchaser would win in this case because he or she already has your $200 in their account.

But let’s say ACME posted the quarterly earnings in the second week of the contract and the stock soared to $47. Now you have a profit and can exercise your option which would require the seller to supply you with 100 shares @ $40 which you can turn around and immediately sell for $47. Now you have made $7 per share minus the cost of the option $2 per share = $5 per share times 100 shares or $500. Not bad for two weeks non-work huh? :)

Now let’s take a look at it from the seller’s point of view.

Keep in mind this is just the opposite of the buyers situation. Let’s say you’re the seller.

You decide to sell a contract for 100 shares of ACME at a $40 strike price for $2 with an expiry three weeks out.

A call buyer purchases the contract from you.  Unlike the buyer who has the option of exercising the contract, you have the obligation to supply the 100 shares of ACME at $40 any time during the next three weeks. The ball is in the buyers court. If the buyer decides to exercise the option you must supply the shares.

If you don’t own the shares you must buy them at the current market price regardless of what that is and turn them over to the buyer.

But taking the above example let’s say the stock only moves to $41.50 at expiration. the buyer has no reason to exercise the option because he or she already has $42 into it. ($40 strike plus the $2 option)

So in this case you just made $200 for doing absolutely nothing! As long as the price of ACME stays below $42 for three weeks you, as the seller, have nothing to worry about. The buyer lost his $200.

But now let’s look at the other example from above.

The stock price goes up to $47 and the buyer exercises his option and you must supply him or her with 100 shares of ACME at $40. If you already owned the stock you would just sell 100 of your shares to him or her.

If you don’t own the stock, you must buy it at $47 per share and then sell it to him or her at $40. Your loss as a buyer in this case is $7 times 100 shares minus the premium you already have been paid. So 7 X 100 = $700 – $200 = $500 loss.

All of this just goes to illustrate that when the buyer wins the seller loses and vice versa.

By now you should understand there are two basic types of options contracts, calls, and puts. You should also know that one can buy or sell either of them.

So….

You can buy calls.

You can sell calls.

You can buy puts.

You can sell puts.

This seems a little complicated when you think about all the combinations you could enter into, but stick with it and it will become clearer. :)

In the next lesson we’ll reinforce calls with a couple more examples.

Until next time, happy trading!

Trader X

Click here to move on to Lesson 4