A Practical Guide to Options

Nov 4, 2006 by Adam C. Powell, Ph.D.

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.

How are options priced and sold?: While the reported price of an option is the price of an option on one share (i.e. the right to either buy or sell one share of XYZ at a certain price), in actuality, you must buy options in “contracts” of 100 options. Options, like stocks, have “bid” and “ask” prices. The “bid” is the price at which you can resell your option, while the “ask” is the price at which you can buy an option. The ask is always higher than the bid. The difference between the two, the “bid-ask spread,” represents the profit made by the Market Maker in matching buyers to sellers in the options market. It’s kind of like eBay. The house takes a small cut of the transaction. Brokers usually charge a commission for trading options, as well as a per-contract fee.
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.