Options are a fascinating part of the financial world. They’re different from other kinds of contracts like forwards or futures because when you buy an option, you get the choice, but not the duty, to make a trade. This makes options a flexible tool for savvy investors.
The first steps into the options market involve getting to know how things work. There’s specific jargon to learn, understanding how trades happen, and figuring out margin requirements. While the main focus is on stock options, there’s also a brief look at other types like currency and index options, with more details to follow in later pieces.
When it comes to costs, options are unique. You don’t pay anything to enter into a futures contract, except the margin. But buying an option means paying upfront. This upfront cost is a key part of options trading. When people show how much money they’ve made or lost with options, they usually just talk about the difference between the final value and what they paid at the start.
Options come in two main types: call options, which let you buy something, and put options, which let you sell something. Each option has a set date and price for when and how you can use it. There are also two kinds of options: American and European. American options can be exercised any time before they expire, while European options can only be exercised on their expiration date. American options are more common, but European options are simpler to work with and help investors understand American options better.
Understanding Call Options: A Basic Guide
When investors dabble in options, they’re dealing with the potential to buy or sell a stock at a predetermined price. Take a European call option, for example. Imagine an investor who buys this type of option with the aim to purchase 100 shares of a stock at a strike price of $100. If the stock’s current price is $98 and the option expires in four months at a cost of $5 per share, the investor’s initial outlay is $500.
Since this is a European option, the investor has to wait until the expiration date to exercise the option. If the stock price on that day is below $100, the investor would refrain from exercising the option, as it wouldn’t make sense to buy at $100 when the market value is less. The result? The investor would lose the initial $500 investment.
But let’s say the stock price rises to $115 by the expiration date. The investor can then purchase 100 shares at the agreed strike price of $100 each. If they sell these shares immediately, they stand to gain $15 per share, equating to $1,500, not counting any transaction costs. Subtracting the initial cost of the option, the investor nets a profit of $1,000.
It’s also worth noting that sometimes exercising an option might still result in a loss. For instance, if the stock price reaches $102 at expiration, exercising the option would lead to a $200 gain but, after factoring in the $500 spent on the option, the investor is still down $300. This might seem counterintuitive, but it’s better than not exercising the option at all, which would result in a total loss of the initial investment.
Understanding Put Options: A Basic Guide
On the flip side, we have put options, where the purchaser is banking on a drop in the stock price. Consider an investor who acquires a European put option to sell 100 shares of stock at a strike price of $70. If the current stock price is $65, the option lasts for three months, and each option costs $7, the investor has made an initial investment of $700.
With a European put option, the action happens only if the stock price falls below the strike price on the expiration date. For example, if the stock price is $55 when the option expires, the investor could purchase 100 shares at $55 and then exercise the option to sell them at $70 each. This would result in a profit of $1,500, and when deducting the initial $700 for the option, a net profit of $800 remains.
However, there are no guarantees in the market—if the stock price ends up above $70 at expiration, the option becomes worthless and the investor loses the $700 spent.
American vs. European Options and Early Exercise
It’s important to differentiate between American and European options. Unlike European options, which are exercisable only at expiration, American options can be exercised at any time before the expiry date. This flexibility can be advantageous, and as we’ll explore in later discussions, there are certain situations where it’s preferable to exercise American options early.
Contract Specifications
In the complex world of options trading, each contract is a tug-of-war between two parties: the buyer, who holds what’s called the long position, and the seller, or the writer, who holds the short position. The buyer hopes to gain from market movements in their favor, while the seller receives immediate payment but faces future liabilities.
Let’s break it down further:
- Long Position in a Call Option: The buyer hopes the stock price will rise above the strike price.
- Short Position in a Call Option: The seller gains if the stock price stays below the strike price.
- Long Position in a Put Option: The buyer benefits if the stock price falls below the strike price.
- Short Position in a Put Option: The seller profits if the stock price remains above the strike price.
The concept of payoffs is central to understanding options. For a European call option, the payoff is the excess of the final stock price over the strike price, but only if the final price is higher. For the writer, the payoff is the negative of the buyer’s. Similarly, for a European put option, the buyer’s payoff is the excess of the strike price over the final stock price, if the strike price is higher.
Now, focusing on the American-style stock options commonly traded in the United States, these options are distinguished by their flexibility, as they can be exercised anytime before the expiration date.
The expiry dates of these options fall into a monthly cycle, and the precise expiration is typically the Saturday after the third Friday of the month. The last day of trading for these options is the third Friday, with investors needing to instruct their brokers by the end of this day if they wish to exercise.
The strike prices are set by the exchanges and vary depending on the stock price. These prices are spaced at intervals – more closely when stock prices are lower, and wider for higher-priced stocks. As the stock price fluctuates, new strike prices may be introduced.
Options are categorized based on their relationship with the stock price at expiration:
- In the Money: The option has intrinsic value and can be profitably exercised.
- At the Money: The stock price and strike price are equal.
- Out of the Money: The option has no intrinsic value and exercising it would not be profitable.
The intrinsic value of an option is its immediate exercise value, while the time value represents the potential benefit from holding the option. The total value of an option is the sum of its intrinsic value and time value.
This dynamic landscape of options trading offers a variety of strategies for traders, from immediate gains to long-term bets on market trends. Understanding these fundamentals is key to navigating the options market successfully. Continue to the next part of this guide here.