9-01 What Are Options?
Have you ever wanted to buy an expensive stock like Netflix or PayPal but you can’t afford to buy 100 shares? Options give you the right to participate and have exposure in these expensive stocks, but you are not required to use that much personal capital.
Generally speaking, options are used in many areas of business and investment. Employees of larger companies frequently get stock options as an incentive to stay with the company for a long time and help the company increase in value. A lot of real estate transactions involve the option to purchase additional neighboring acreage at a certain price within a certain number of years. And even leasing a car usually contains a “purchase option” at the end of the lease term.
So what is an option?
In its simplest form, an option is an agreement that gives the holder of an option the right, but not the obligation, to buy (or sell) something at an agreed upon price by an agreed upon time. Sometimes, the holder or buyer of the option pays a fee to the seller in order to have this right.
Real Estate Option
In this real-world scenario, you and your spouse find the perfect home that you’d love to buy. The only problem is the timing, as you won’t be in position to purchase the home for around six months. You and the seller agree to a price to purchase the home up to six months from now. For this seller concession, you agree to pay $2,000 (non-refundable if you chose not to buy) to the current homeowner. This contract gives you the option, but not an obligation, to buy that house at the agreed upon price at any time for the next 6 months.
In the investment world, the “house” in our example becomes a stock and is called the “underlying security.” The agreed upon price is called the “ strike price ” and the end date of your agreement is called the “expiration date.” The important factors are the agreement, the selling/buying price, the cost of the option, and any conditions to which the parties agree.
Stock Option
In this scenario, we have two individuals, trader A and trader B. They think the price of APPL will go up in the next 3 months. Trader A thinks it will go to $150 and the other one thinks it will go up, but not above the strike price of $150. So, each trader will place a different option trade and the expiration of this contract will be in two months.
- Trader A will be a buyer of an option contract and will pay the Premium
- Trader B will be the seller of an option contract at $150 and will receive the Premium
Each contract represents 100 shares of the underlaying stock. If trader A buys 1 contract for example at $4.35, (this is the Premium) trader A will pay trader B $435, ( $4.35x 100 = $435).
Trader A wants the price of APPL to be above $150 before expiration (2 months) so he can maximize his gains. On the other hand, trader B wants the price to be below $150 by expiration so he will keep all the premium. If the price does not reach the strike price, trader A does not have to exercise the option. It will expire worthless.
Summary
To review, here is the real world option language verses and the investing option language:
| “Real World” language | Investor language |
|---|---|
| House: | Underlying Security (ie, Stock) |
| Buying price: | Strike price |
| Date agreement ends: | Expiration date or Expiry |
| Actually buying the house: | Exercising the option |
A key difference between this house example and stock options is leverage. Stock options allow investors to buy 100 shares of stock in a single option contract. For the rest of this chapter, remember that a single option contract covers 100 shares. So when we say an option is trading at $1.25, that means that option contract will actually cost $125.
As you will see, options can play a key and often times exciting role in your investment success. Let’s get started…