While trading in the stock market has been around since recorded history, Options have only been traded on a formal exchange since 1973. It was in this year the Chicago Board of Options Exchange (CBOE) was organized. Inexperience investors, those trying to increase their net worth in $100 to $5,000 increments, are not familiar with many of the “terms” used in these transactions and are reluctant to consider them at part of a strategy.
There will always be an edge of caution with the unknown. The result is a mystique, fueled buy horror stories about money lost and how risky the options market is. The Options market is risky, as is the stock market. But the key to either success is knowledge, understanding what the risks are and in tilting the playing field in our direction. For instance, when I buy a stock, I don’t know the price will go up. But if I buy when the price trend is favorable, with the technicals suggesting strong upward support, the fundamentals of the company convincing me it isn’t going into bankruptcy soon, and there are no “news” stories in the press creating clouds on the horizon, I will have improved my odds of success. That is not gambling, it’s smart business. It does not mean I will alway be right. It means I’ll be right more often than I’m wrong!
So, what is an option? Here’s an example we can relate to: I bought a home many years ago, leasing the home for X.$ per month with the wording added to the contract, “the option to purchase the home any time before the end of the lease for a Y.$ price.” I had secured the “right” to buy the home for a fixed dollar amount. This “right,” secured by a legal piece of paper, was called an “option.”
If I choose to exercise the option, I would have to come up with the agreed upon price to purchase the home. If I choose not to exercise the option, it would expire worthless. I had paid for the right to “buy” the property for a Y.$ price for the term of the lease, the cost being included in the lease payments. Or, the option cost was paid at the start of the lease at an amount agreed upon. If the option wasn’t exercised within the time frame, I forfeited that payment.
During the time of the lease, if property values skyrocket up or drift down, I could still buy the home for the agreed-upon fixed option price. Now consider how all this relates to the purchase or sale of an option in today’s option market:
1. Option: “A contract permitting its owner to buy or to sell an asset at a fixed price until a specified date.”
The option is the contract, the piece of paper, giving the owner of the option the “right” to buy or sell, within a certain time frame, at some specified value. In the property example above, I could arrange in the contract the right to sell that option if I could find an interested buyer, and receive some commission or reward for finding the buyer. That is, I could treat the option as a commodity to sell for whatever the market would allow.
2. Call: “An option permitting the holder the right to buy a specific asset at a pre-determined price until a certain date.”
In the property example, I would be holding a “call“ option since I had secured the right to buy the property. In the stock market, I can pay for the right to purchase a particular stock by buying a “call“ option, giving me the right, for a certain time, to pay a specified price to buy the stock.
3. Put: “An option giving the holder the right to sell a specific asset at a pre-determined price until a certain date.”
(Calls and Puts are distinct from each other, buying and selling of one has noting to do with the other.)
4. Strike (Exercise) Price: “The price at which the owner of an option can purchase or sell the underlying stock.”
5. Write a Call: “Sell an option. The term write is synonymous with sell in options parlance. The seller then becomes the writer.”
6. Contract Size: “Options are only purchased in contracts, each contract representing 100 shares of the stock.”
7. Premium: “The price paid to the writer (the person who owns the stock) for the rights of the option. It is entirely a non-refundable payment in full and not a down-payment on the stock.”
8. Optionable Stock: “All stocks are not optionable. Very simple, if the options market is buy and selling Options on the stock, then that stock is optionable. To find if a stock is optionable, go to the Home Page of CBOE (www.cboe.com), select Delayed Quotes, enter a stock or index symbol and hit return. If the stock is optionable you will get Call and Put data. If the stock is not optionable, you will be asked to enter another ticker.
9. Called Out: “If the buyer of a call exercises the option, the writer is said to be Called Out. He must sell the call to fulfill his obligation.
10. Covered: “If the writer of a Call owns the stock, he is said to be covered and the option is termed a Covered Call.
11. Naked: “If the writer of a Call does not own the stock, he is said to be Naked, and the option would be a Naked Call.” This is the highest risk option play.
12. Derivative: “An asset that derives its value from another asset.”
Now why are we doing all this? We would only buy a “Call” to purchase a stock sometime in the future if we were convinced its price would go up in the meantime. That is, if we could pay for the right to purchase a stock for $12.00 a share within two months, when we felt like it was going to $15.00 in that time, that would be a good investment. If the stock did go to $15.00, we could buy it for $12.00, sell it on the market for $15.00 and pocket $3.00. The price of purchasing a “call” in this example may be in the $1 to $2 range.
We have controlled a large amount of stock with a small amount of money. We are able to trade more expensive stocks investing a fraction of the price. Sound good? What is the down-side?
Because an option is a fixed-time investment, we lose whatever we paid for the call if it is not exercised by its expiration date. What if the stock does not go up as anticipated? Oops! What if the stock drops in price? Double oops. However, all one loses is the price of the option call.
A call option on a stock is a derivative security that obtains its value from the shares of the stock purchased with the call option. All options are derivative securities. The market value of an option is affected by changes in the value of the underlying asset. What this means is the value of the option changes along with the value of the stock. The importance for us here is understanding that a change in stock price is magnified in the price of the option. A small change in the price of IBM can cause a large price change in a call option on the security. It is this “leveraging” feature that makes options trading such an attractive way to invest money.
For detailed examples of how to exercise the most conservative of all options strategies (Selling Covered Calls), read chapter 8 in our book, “Provident Investing.” This includes a comprehensive explanation of “What Makes it Work!”