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Stock Options – Friend or Foe?

Updated on October 26, 2017

If you own stock in companies, then you need to know something about options. Options can be your friend and help you protect your stock against a drop-in price, that is called hedging. You can sell options against your company stock (if you own at least 100 shares) to generate income, this is called writing a covered call. If you want to just speculate on the direction a stock will go over time, you can buy a Call option if you think the direction is up or a Put option if you think the direction is down for the stock price. Option can be very confusing and I wrote this Hub to help investors understand what they are and how they can be used for protection, income, or speculative profit.

In financial terms, options are financial derivatives. They represent contracts that are sold by the option writer to the option holder. With an options contract, the option holder, or the buyer, has the right to either buy or sell a particular security or financial asset at an agreed on price during a specific time period.

Options are very versatile in terms of how they may be used by different parties in the financial markets. Some traders use options in order to speculate, which is something that carries a fair amount of risk. But options are also useful for hedging the risk associated with holding a particular asset. The reason options are so common in the financial markets is because the writers and holders of the options have drastically different views on how the market is going to play out in the coming months and years. With any given option, the writer and holder are expecting the price of a given security or asset to go in opposite directions during the time period laid out in the option.

Stock Options

Stock options are privileges that are sold from one party to another, where you are giving the buyer the right to buy or sell a particular stock at an agreed price within a particular time frame. Most of the options you see on the market are American options, where the option can be put into effect anytime from the time it is bought to the expiration date. In contrast, European options, which are not as common on the market, are only redeemable at their expiration date. A vast majority of stock options involve 100 shares of the stock in question.

When it comes to stock options, there are two main choices on the table. A buyer can either purchase the privilege to buy or sell a particular stock, which is where the call and put options come into the picture. A call option refers to a contract where the buyer is going to purchase a given stock at a specific price on a particular date. On the flipside, a put option refers to a contract where the buyer can sell a given stock at the price agreed on by both parties, and before a set date.

Why Own a Stock Option?

But why would someone want to own a stock option? It depends on whether the buyer is interested in a call or put option. With a call option, the buyer believes that the price of the stock is going to increase over time, while the seller is assuming it is going to decline. If both parties agree on the buyer having the right to buy 100 shares of stocks at $30 a share at any time within the next 12 months, the buyer would ideally want to exercise the option when the share price is at its highest. The agreed-on price between both parties in a call or put option is referred to as the strike price of the option.

For instance, the price may rise to $40 a share after six months. If the buyer exercises their option, they would be getting those 100 shares of the stock at a price that is $10 a share cheaper than the going market rate. They could theoretically exercise their option, own those 100 shares of the stock, and sell those shares on the market at the $40 a share price to make a solid profit on their investment.

If the above scenario were to take place, the seller would lose out, because they could have held on to the stock and sold it after six months when the price was at $40 a share. The only time the seller is going to profit from a call option is when the price of the shares goes down during the period where the call option is active.

For a put option, the buyer of the option is going to benefit if the stock’s price declines over the period when the option is active. For example, both parties agree to a put option with a strike price of $32 a share. The buyer believes the stock is going to experience a decline in the coming weeks and months. If the buyer is correct, and the stock’s price goes down to $25 a share, the option holder now has the choice of selling the stock at the $32 a share strike price. They would effectively make a profit of $7 per share, given the discrepancy between the current market price of the stock and the agreed-on strike price.

Put and Call Options Video for Beginners

Options vs. Stocks

Beginning investors can be confused about the difference between options and stocks. With a stock, the investor is spending money in order to buy a specific piece of a company. For instance, a trader may buy 100 shares in an energy company. They are effectively gaining a small percentage of ownership of the energy company through those 100 shares.

In contrast, options offer no ownership by themselves. An option is simply a contract that is giving the buyer the right to buy or sell the stock for a specific price at a future date. If the buyer engages in the option, they would be buying the stock, which means they are buying ownership into a company. But the buyer may choose to never exercise the option, especially if the stock’s price does not flow in the direction they were anticipating.

The easiest way to compare the trading of stocks and options is to compare them to real world scenarios. Many investors liken trading stocks to gambling at a casino. When you are trading stocks, you are effectively betting against the house. If every customer, or stock trader, has a good amount of luck, they could all win. And it is exactly what happens when the market goes through a bubble period, where the vast majority of stock prices rise.

When it comes to trading options, we can compare it to betting on horse races. Similar the horse races, where some people have to lose in order for others to win, trading options is a zero-sum game. It is not possible for both the buyer and the seller of the stock option to both win. If one party is to win by a particular amount, the other is losing by the same amount.

What Do Options Cost?

There are prices attached to options, with these pries known as the option’s premium. When a buyer engages in a put or call option, the maximum amount of money they are going to lose is the premium they are paying for the option. If the trajectory of the stock’s price does not go in the direction they were hoping, the buyer can simply cut their losses and refuse to engage in their buying or selling option. In theory, the buyer has an unlimited potential to make a profit, depending on how the stock’s price rises or falls during the option period.

With a call option, if the stock price is greater than the strike price on the market, investors say the call option is “out of the money”. If the current price is below the strike price, the call option is considered “in the money”. And the reverse is true with put options, where “out of the money” means the strike price is higher than the stock price, with “in the money” referring to a strike price that is lower than the current stock price.

Time Value and Intrinsic Value

The difference between the current price of the stock and the strike price of an option is the intrinsic value. Any amount of the option’s premium that is in excess of the intrinsic value of the option is called the option’s time value.

For a call option, the intrinsic value is equal to the underlying price of the stock minus the strike price. For a put option, the intrinsic value is the strike price minus the underlying price of the stock.

To break it down, the time value of an option is equal to the premium of the option minus the intrinsic value of the option. When there is more time remaining before an option expires, it going to have a greater time value and will cost more. The reason for the greater time value is because investors are happy to pay a higher premium for options contracts where they have more time to exercise their option. More time means more opportunities for the option to become profitable for the buyer.

As a rule, stock options lose around a third of their time value during the first half of their life. The remaining two-thirds of the option’s time value erodes during the second half. The time value is going to keep decreasing over time, which is referred to as time decay. Provided the underline stock price does not change, the time value of the option erodes to zero at expiration.

Generating a Little Income - Writing a Covered Call

When you own at least 100 shares of a stock, you are entitled to a few rights. One of the rights of a stock owner is the ability to sell the stock at any time at the current market price. By writing a covered call, the stock holder is selling this particular right to someone else in exchange for immediate cash. It means you are providing the buyer of the option with the chance to buy your shares before the option expires at a given price, at the strike price.

Covered calls are options strategies where the investor has a long position on an asset, and writes call options on the asset in the hopes of generating some income from the asset. The long position refers to the act of buying a security in the hope that its price will rise over time.

As an example, we can take a trader who buys 100 shares of stock A at the price of $35 per share. They sell a call option for one month in the future at a premium of $1 with a strike price of $38. If you sell the option, you are bringing in a total of $100 in premiums. The cost basis of the stock is $35. If the date arrives a month later, and the price of the stock is at $38 or below, you can expect your option to expire worthless. You keep the premiums and you can now write another option if you want. You just made $100!

But if the price of the stock is above $38, you can expect the option to get called. You will have to sell the stock at the strike price, which means you are going to make a total of $4 on each share. $3 for the difference in price from what you bought it at to the strike price, and $1 for the premium.

Most traders who use the covered call strategy will employ it with stocks that have a consistent price. If the price is not rising or going down by much, you can continue to write options and bring in premiums.

Putting it all Together with an Example – Walmart (WMT)

This is a stock chart for the Nov 4 2016 options on Walmart stock from October 26, 2016. The chart shows both puts and calls. The yellowed areas indicate options that are “in the money.” If you are bullish the stock price will increase, the you would buy a call option, say the 69.6 Call for 0.72 (or $72). If the stock price goes up so does your option price. If you exercise your option, you can buy 100 shares of Walmart for 69.5 any time before expiration on Nov 4 2016 or sell the option at a profit. If the price of Walmart drops below 69.5 and stays there until expiration, then you lose money and the option expires worthless. If you think the price will drop, then you buy a put option.

Take the case where you own 100 shares of Walmart and want to generate a little income. You sell the 70 call for 0.41 (or $41). This would be a covered call. Now if the price stays at 69.59 or drops a little between now (10/26/2016) and the expiration of the option then you profit $41, less brokerage fees. If the price of the stock rises to $71 you have two options: 1. Buy the call option back at loss, or 2. Let the option expire and you option will be called and the owner of the option will probably by the 100 shares of stock at 70. You lose the stock buy you gained the $41 for selling the option. At this point, you can either buy the 100 shares of Walmart back or be happy with your profit and move on.

Source

Be Cautious With Company Option That Low Liquidity

One thing you want to be careful about when buying or sell options is to make sure there is plenty of liquidity in the options market for your company. Take for example, the case of Tyson Foods, Inc., this is a company with over 20 billion dollars in market capitalization yet there isn't much action with the options (see the options table below). Note the difference between the Bid and Ask prices are larger than the example of Walmart previously discussed. When there is low volume on a particular companies option, the Bid/Ask spread will be larger and you will have more trouble entering and exiting a trade - just a point of caution.

Tyson Foods, Inc. (TSN) options for November 3, 2017.
Tyson Foods, Inc. (TSN) options for November 3, 2017. | Source

Disclaimer

Buying and selling stocks and options can be a risky proposition. Consult your financial advisor before making any stock or option purchases.

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    • dougwest1 profile image
      Author

      Doug West 13 months ago from Raymore, MO

      Thanks. I trade options frequently so I thought I would write about them.

    • Larry Rankin profile image

      Larry Rankin 13 months ago from Oklahoma

      Great analysis!