Introduction to Call Options (1)

I have used an option on land as an analogy to help explain the concept of options.  Hopefully, it will serve that purpose well.  In fact, options on various items exist in many business markets and segments so it's likely you may have run into them before.

An option represents a legally binding agreement whereby the option buyer purchases the right to buy an item represented by the option, at a predetermined price, by no later than an agreed deadline.  For example, with respect to an option on land, the Owner of Blackacre, a potentially attractive piece of land which Owner just bought for $50,000, is willing to sell a Developer an option on this property.  Owner and Developer agree that Developer can purchase the right to buy Blackacre no later than November 1, 2009 for a price of $55,000.  The price for this option right, known as the premium, is set at $5,000.  As is almost always the case, the option price is non-refundable so Owner keeps the option premium no matter what happens; whether or not Blackacre is sold to Developer.

While Developer can walk away and decline to buy Blackacre, Owner is obligated to sell the property to Developer at the agreed price of $55,000 if Developer decides to exercise his option on or before November 1st.  Obviously, Developer is not going to exercise if Blackacre is worth less than $55,000 by November 1st, the price level above which Developer makes a profit.  

In this case, Developer is entitled to all profits from Blackacre after the option is exercised while Owner will be limited to a profit of $5,000 on the property itself plus the option premium, less commissions.  In short, if Developer decides that Blackacre is worth less than $55,000 when November 1st comes around, he can simply decline to purchase Blackacre, losing only the cost of the option he purchased.  In other words, the option buyer’s risk of loss is limited to the premium paid, plus commissions.  The option seller’s risk is that he foregoes all profit above the strike price and is left holding on to a less attractive property if the price goes down. 

Note that in this real estate based example, there are probably few buyers around who can purchase the option from Developer should he decide to sell it.  That is not the case with listed options where there are many buyers available to whom Developer can sell.  In a listed options market, Owner can buy an identical option to the one he sold and thereby close out his position.  More on this later in the discussion on characteristics of options.

Similarly to the Blackacre situation, in the stock market, you or I can buy a listed option on a particular stock, say IBM, because we think, as Developer did with Blackacre, that it’s a potentially attractive property.  In addition, by purchasing an option at this time, we can wait and see if our estimate of IBM’s value is correct before putting up all the money required that would be required if we were to purchase 100 shares of IBM today. 

Assume that IBM is currently selling at $75 a share and that I decide to purchase an option to buy these shares by next November at a price of $80 a share based on my current stock study based evaluation of IBM.  Let’s further assume that this option is listed at a cost of $1.70 per share.  Since options sell in 100 share bunches, meaning that an option is written on and controls rights with respect to 100 shares, I’m obliged to pay $170, the premium, or $1.70 x 100 (plus commissions) for this option. 

As the option buyer, I now have the right to purchase those 100 shares of IBM at $80 a share up to the expiration date of the option, but I have no obligation to do so, in the same way as Developer could decline to buy Blackacre. Further, as the holder of a listed equity option, I don’t have to hold it until expiration or exercise to sell it if I want to.  In other words, I can sell my option to another buyer before the expiration date to capture an increase in the value of the option without having to buy and then sell the 100 shares of IBM that I control as an option owner. 

Please note that you can buy more than one option at a time.  I’m only using a single option in the workshop as the basis for explaining and discussing options at this time.  We’ll get into the details of how many options to buy or sell at a later time.

The option described above is known as a call option.  The name is derived from the concept that as the option buyer or holder I can “call” the stock, or parcel of land in the case of Blackacre, away from the seller at the terms and prior to expiration of the period specified by my option.  Simply put, a call option is an agreement to buy whatever the option covers; a piece of land, a painting or shares of stock at an agreed price (the strike price) by a specific time (the expiration date) for an agreed amount (the premium).  It should be noted that an option is good only to its expiration date.  After expiration, an option has no market value.

Saul...

Introduction to Call Options (3)

Generally, the seller of a call option believes that the price of the underlying will stay flat or rise or decrease slightly.  In many instances, the option seller doesn’t mind if the underlying stock rises to the strike price and the option is exercised since the seller gets to keep the premium and any increase in price over what was paid for the underlying stock if the seller was covered or owned IBM in this instance.   However, the option seller cannot enjoy an increase in the price of an underlying if it rises above the strike price since the call will be exercised and the seller will have to surrender ownership of the underlying, the 100 shares of IBM in this case.

Attached to this message are risk profile charts for a call option.  These charts are in common use in the options community and are found in many books and websites on options although the charts are not used as often by option newbies as they should be.  This is especially true if one decides to trade complex option strategies where you must know how the several legs of a complex strategy work on an individual basis to be successful.  In any event, you should completely understand all aspects of the two basic call risk profile charts found in the attachment before you make your first option trade. 

As the risk profile for buying a call option shows, the buyer can make a profit only when the price of the underlying exceeds the strike price by the premium cost.  The seller of a call option gets to keep the premium and makes a profit even if the price of the underlying drops, but not below the strike price less the option.  If the option seller (also called the writer) owns the underlying shares on which the option is written, that trade is known as a covered call.  The trade is termed a “naked call” if the underlying shares are not owned by the call writer.  For the covered call writer, there is the added risk of owning an asset that is heading south. 

Covered calls will be discussed in the Strategies section of the Workshop.  The varios aspects of selling calls, both covered and naked, will also be covered later in the workshop. 

By the way, you may hear or have read about the outcome of options, that X% of them expire worthless.  I've seen X vary from 65% or so to as high as 90%.  This statement is more than a little misleading and paints options with an undeserved speculative gloss since many options are bought for hedging or insurance purposes, not for pure profit plays.  The buyers in such cases hope and expect their hedging options to expire worthless.  In other words, you don't want to collect on your insurance.  Most importantly, as with all investment vehicles and strategies, an option buyer or seller must fully understand their nature and purpose and use them wisely and within their risk tolerance. 

We’ll next take a look at put options followed by a discussion on the characteristics of options.

Saul…

Hi Barry,

I'm going to adopt Matt Willms private response to you on your call chart question.  Thank you Matt.

Your understanding is correct.  As Matt explained, "The point at which the dashed line crosses the horizontal line represents the option strike price + the option premium paid to purchase the call option.  So for example, if the strike price was $10, and the premium paid for the option was $1, this point on the horizontal line where the dashed line crosses would be $11.   As you move to the right on the horizontal line, the underlying share price is rising (> $11), which means your profit is increasing as the dashed line is rising up and to the right for buying this call option.  

Saul...

Introduction to Put Options (1)

Let’s revisit my prior Blackacre option example. 

Suppose that Owner is now concerned that economic conditions or a change in where that freeway ramp will go might drive Blackacre’s price down by a considerable amount leaving him owning real estate that’s worth a lot less than the $50,000 he just paid for this asset.  Owner is aware that there are other parties who may be interested in selling him an option which would obligate them to buy Blackacre from Owner for $45,000 before an agreed date of November 1, 2009. 

These third parties feel fairly certain that the price of Blackacre will not fall below $45,000 so they are willing to take the risk of having to buy Blackacre since they also get to collect the premium Owner will pay them.  That way, Owner is protected from any price drop below $45,000, less the premium paid, if the market for Blackacre should drop that much before November 1st.  Further, the option seller thinks it wouldn’t be too bad to own Blackacre for 10% less than Owner paid for it.  In this scenario, Owner is willing to pay that premium to get the price protection being sought.  Owner is simply hedging or insuring his position in Blackacre and the option seller is very willing to sell Owner that option based insurance.

Assuming this deal is made, if Blackacre retains a value above $45,000 up to and including November 1st, Owner has no reason to exercise or sell the property.  However, should Blackacre fall below $45,000 before or on the expiration date of the option, Owner can sell Blackacre to the option seller at $45,000 and will have thereby limited his loss on Blackacre to $5,000 plus commissions.  I’m assuming here that Owner can get the option seller or another real estate investor to buy the option back.  That assumption would not be necessary in the case of a listed option.

Similarly, in the stock market, you or I can buy an option on a particular stock we own, say IBM, because we think, as Owner did with respect to Blackacre, that IBM’s stock has the potential to fall significantly in price, a risk we’re not willing to take.  To accommodate that risk, we’ll buy an option, one called a put option.

Saul...

Introduction to Put Options (3)

However, a put option buyer who does not own shares of the underlying stock and is not trying to insure or hedge an actual position, is buying out of conviction that the underlying will not decrease below the strike price by more than the net premium collected.  This put buyer is willing to own the stock at the strike price or to buy back the put he sold if he changes his mind about the wholesomeness of the underlying at a later time.

For a put option buyer, this means that the underlying has to decrease in price by at least the value of the premium (direction and size) before expiration.  Note carefully that a put option buyer’s total exposure or risk when the underlying is put to him is not necessarily limited to the cost of the option plus commissions, since forced purchase of the underlying can lead to further loss if the underlying decreases further in price before it can be sold.  On the other hand, the underlying can increase in price after being acquired, if the put seller’s original premise was correct, in which case the put option will likely expire unexercised.   The use of put options is a frequent basis for acquiring what are considered to be overpriced, but otherwise quality investments, at a more reasonable price.

I think it’s fair to say that a put option buyer is more of a speculator than an investor, except for those instances where puts are purchased in order to insure or hedge positions taken in the market.  This aspect of put options will be explored further in the strategies portion of this workshop.

Generally, the seller of a put option believes that the price of the underlying will stay flat, rise in price or decrease down to no less than the break even point.  In many instances, the option seller doesn’t mind if the underlying stock falls below the strike price and the option is exercised since the seller gets to keep the premium and buy the stock at a discount to its price at the time the put option was purchased.  Brokers usually require a put seller to have sufficient account equity, cash is often what’s required, to secure a put the seller has sold to make certain that there’s sufficient cash in the seller’s account to buy the underlying if the put is exercised.  This aspect of put options will be discussed in the upcoming Strategies section of the workshop. 

In U.S. markets, assuming you are approved to trade put options, and approval has 5 levels conditioned on one’s experience and net worth, one can buy or sell put options on stocks, ETFs, commodities, currencies and other items that are traded on various exchanges.  The amount of money a put seller has to have in their account is a function of the option level you are qualified to trade at.

Next, we’ll take a look at some important characteristics of options.

Saul…

Option Characteristics (3)

Strike prices are considered to be one of the most important option characteristics.  Strike prices are usually stated in $2.50 and $5.00 increments.  Strike prices in increments of $1 have been instituted for a number of stocks on a trial basis.  This program was recently made permanent for about 55 stocks (a few original stocks on this list are no longer traded).  Strike prices for existing options are adjusted in the case of splits and stock dividends.  While relatively rare, such adjustments may result in fractional strike prices and in option scope for other than 100 shares per option contract.

Stock option premiums have historically been quoted in fixed increments of a nickel ($0.05) if the option premium is less than $3.00 and a dime ($0.10) if the premium is $3.00 or more.  However, an expanding pilot program has permitted option quotes in penny increments for a limited set of underlying stocks.  This is a long overdue change for non-institutional option traders.

So, for a limited set of options, strike prices can be in $1 increments and premium prices can be in penny increments.  This is good for us retail option traders.

Currently, there are a total of 63 option classes trading in one-cent increments, which covers close to 60% of option exchange volume. Generally, penny increment pricing has been positive for the retail investor because it has narrowed bid/ask spreads and reduced customer costs.  It has made my option trading easier and more profitable by a modest amount.  However, the high volume institutional traders have voiced concerns over liquidity and transparency with respect to penny pricing meaning this is something to keep an eye on. 

Option trades have a one-day settlement period as contrasted with three-day settlements in the equity and bond worlds.  An option trade settles on the next business day after the trade. Purchases must be paid for in full, and the proceeds from sales are credited to accounts on the settlement day.  That also means that premiums you are entitled to by virtue of selling an option show up in your account the day following a trade and are available to you once they do.  Keep in mind that a few brokerage firms require settlement on the same day as the trade, when your trade occurs on the last trading day of an expiration series.

Next is an explanation of option “moneyness” and option intrinsic and extrinsic values.

Saul…