# A Practical Guide to Options

Nov 4, 2006 by

My last entry gave a vague overview of the power of options. Now, I’m going to explore the practical details of using them.

Here are some answers to some common questions:

When do options expire?: An option expires on the third Friday of its month of expiration. Thus, options set to expire in November 2006 have the expiration date 11/17/06. An American option can be exercised at any time until it expires. As a result, the value and price of an option declines over time.

Currently, a “put” option on IYY, expiring in November 2006, with a “strike price” of \$68 has an “ask price” of \$2.10. How much would this option contract cost me on Scottrade? Well, it would cost me \$2.10 * 100 (as a contract contains 100 options) + \$1.25 (contract buying fee) + \$7.00 (commission). Thus, 100 of these options (a contract) would cost me \$218.25. If the stock rose \$1 to \$69, someone who had purchased options would have lost \$1.18 per option, for an overall loss of \$118.25. If the stock rose to \$80, the person would have made \$9.82 per option, for an overall profit of \$981.75 for the options contract. Note that if the person had instead purchased 100 shares of the stock at \$68, they would have made \$100 – \$14 (commissions) = \$86 when the stock rose to \$69, and would have made \$1,200 – \$14 = \$1,186 when the stock rose to \$80. If the stock sunk to \$60, a person who bought 100 options with a st

What determines the underlying price of options?: The prices of options are determined using the Black-Scholes formula. This formula is rather complex, and was not discovered until 1973. Its creators later won the Nobel Prize in Economics for discovering it. To learn more, see http://en.wikipedia.org/wiki/Black-Scholes

Here is an example:
Diagram of the Effects of Call and Put Options
Imagine that the price of a fictitious stock is \$50 today. An option expiring in the next month with a strike price of \$55 can be purchased. As the option-writer undertakes some risk, the all of the options have a \$2/share risk fee. However, the put option costs \$7 while the call option only costs \$2, as by using the put option instantly, one could make \$5. (A put option is the right to sell at the strike price. As the strike price is \$55, and the current price is \$50, the put options are in-the-money \$5 at the time of sale.)

What would happen if the stock price fell to \$40? People holding the call option would not use their options (why buy the stock for \$55 using the option, when it can be bought on the market for \$40). People using their put options would use their options to sell the stock at \$55 instead of at \$40. Thus, the people holding the call options would simply lose the cost of their options (in this case, \$2 per share). If they had held stock instead of options during this time, they would have lost \$10 per share. People holding the put options would exercise their options and lose \$2 (the price of the option’s risk absorption), as opposed to losing \$10, as they would have without the option’s risk protection.

What would have happened if the stock rose to \$60? People with call options would make \$3 per share (-\$2 + \$60 – \$55). If they had instead held stock, they would have made \$10 per share. People holding put options would simply lose the cost of the option (\$7), as they would rather sell their shares at \$60 than at \$55.

Now, imagine that you wanted to “leverage” your investments, and use options without actually owning the stock. If you owned a put, and the price fell to \$40, you could buy some of the stock on the market, and then instantly resell it with your put. You would only have to pay \$7 per put option, instead of paying \$50 for the initial shares. Thus, you could afford far more put options than you could afford shares. Given the \$15 in share price, you could make \$15 – \$7 = \$8 per option. Thus, a \$7 investment could yield a return of \$8, a 114% return! Similarly, if you owned a call option and the stock price rose to \$60, you could make \$3 on a \$2 investment, a 150% return! Note that if the options don’t work in your favor, you could end up with a very negative return. If the stock price went in the wrong direction, you would receive a complete loss on your investment. However, if you had owned the underlying stock, your potential for percentage gain and percentage loss on investment in this scenario are in a much smaller range.