The equity option
There are many different types of options.....Real estate options, Forex options, futures options, and.....the equity option which is what I am here to talk about today.
All options are derivatives. No not like the calculus class that you were required to take in college. A derivative in the equities world is derived from the stock that it underlies. An option has no ownership in a company. It is basically just a right.
Ok, you have got to be kidding. Why in the world would anyone want to buy something of no worth?
It actually does have some worth. Here let me explain what the right is.
There are call options and there are put options.
A call option is the right to buy a stock at a set price for a set time. It gains value when its' underlying stock rises.
If a person held a $500 dollar March call on GOOG (Google), they would have the right to buy GOOG for $500.00 until the third Friday in September. Hey that is not too bad, GOOG is at $534.62 currently and this $500.00 dollar call would allow a person to buy GOOG for $500.00 instead of $534.62.
A put option is the right to sell a stock at a set price for a set time. It gains value when its' underlying stock drops.
Now if a person held a $570 dollar September put on GOOG, they would have the right to sell GOOG for $570.00 even though GOOG is only at $534.62..
Ok, whats the catch. How much would these call and put thingies cost?
A 500 call option would cost $45.50 and a 570 put option would cost $43.20.
I knew it...Too good to be true. These options cost more than the difference in the stock and the right they give. Whats up with that?
Here is the allure of options.
If a person were to buy GOOG, it would cost them $534.62. The call option would cost only $45.50. That is almost 11 x leverage. So if GOOG went up to let's say $650.00, a person holding the stock would have a gain of around 22% (Gain=115.38/current price=$534.62). That is not too bad. When one looks at the option, this option will be worth at a minimum the difference in the strike and the current price or the amount of money that the right allows. So we know that this right allows a person at minimum a $650-$500=$150 value. Now, this person only paid $45.50 for this option so they would have a gain of $150/45.50=3.3 or a 230% gain. Wow!!!!!!
Now if you think that is crazy, a person can buy a call option that has no apparent value for very cheap. An March 730 call option could be bought for ten cents. If GOOG were to rise to $750.00 (before the 3 Friday in March) this option would have a value of at least $750.00-$730.00=$20.00. So this call holder would have a gain of $20.00/$.10=200 or a 19900% gain. In fact if this person bought $5,000 worth of these calls, he would have a cool clean million dollars. (Less commisions and spread fills of course)
Now the allure can be seen. In fact back in late March, a tiny biotech company called Dendreon DNDN went from $5.22 to $17.92 over night. There were some people made 200 x their money. I am sure that some people that were holding cheap options were worth millions.
But.................Many of these same people were holding these same options on May 8th when DNDN dropped from $17.74 to $6.33.
Why in the heck would someone who made so much money not sell?
They were waiting for a May 15th approval by the FDA (which was cut short on questions of efficacy by the FDA) and had thoughts that DNDN would be a $60.00-$80.00 stock. If 200x is good, 800x is better. These options were basically worth zero.
Well they can just wait until DNDN goes back up right?
No, an option is a wasting asset. Unlike a stock which a person can hold as long as they want, an option expires. When it expires it goes bye bye and the right doesn't exist anymore. In fact it is said that 80% of all options expire worthless. Options also lose value with time.
You see, some options are basically a lottery ticket. I can't say that I haven't hit the option lottery so to speak. I also lost far more than I gained in long option play. There are people that have lost their houses basically gambling on options.
Hey you trade options don't you Ben? After this big lecture, you must be just plain stupid or at least crazy.
I do but I need to tell you that there is a buyer and a seller in the option game. In fact a person can buy and sell options at the same time and these are called spreads.
Now with spreads a person can structure a trades that make money even when the stock goes flat (stays at the same price). A person can also structure a spread trade so it makes more money as time goes by.
However, options are tricky and if you don't understand their behavior....."Option out"....At least until you have a year trading options on paper (that means fake trading or no money) and fully understand the characteristics.
Please note: Options are bought in contracts of 100 which controls 100 shares of stock. A $45.50 option would cost $4,550.00 per contract and likewise a $.10 option would cost $10.00 per contract. When options are described and priced, the are priced as though they control 1 share even though they are only sold in a 100 lot.
Disclosure: I am not currently long or short GOOG.