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Stock option

A Stock option, commonly called just an option, is the right, but not the obligation, to buy or sell 100 shares of a given stock at a predetermined price at a specified time. They come in two flavors, "puts" and "calls."

They are traded on options exchanges, especially the Chicago Board Option Exchange (CBOE).

This is similar to, but not exactly, employee stock options. Also compare warrants.

In addition to stock options, other kinds of options exist. It is common in business to buy an option for real estate in a pending business venture to insure availability of the property at a specified price until the rest of deal comes together. A futures contract is similar though not actually an option.

Expanded definition

An introduction

Options are derivatives -- they derive their value from an underlying "something else." Before you start using options, it's Foolish to make sure you understand exactly what that "something" is.

We Fools believe that 99% of individual retail investors -- that's you and me -- can happily go through life without ever buying or selling an option. But derivatives themselves (of which options are only one part) aren't inherently bad. The real problems stem from their wide proliferation, and the crazy accounting with which they're associated.

Options are just tools, and they're only as good as the people using them. Shrewd use by well-educated investors can greatly enhance a portfolio's returns. Reckless, ill-informed use of options, however, can badly damage your holdings. To use options well, you've got to have a healthy understanding of the intrinsic value of the business involved. Without that most Foolish of principles, how safe do you feel in using options to leverage returns?

The basics

Options represent the right (but not the obligation) to take some sort of action by a predetermined date. That right is the buying or selling of shares of the underlying stock.

There are two types of options, calls and puts. And there are two sides to every option transaction -- the party buying the option, and the party selling (also called writing) the option. Each side comes with its own risk/reward profile and may be entered into for different strategic reasons. The buyer of the option is said to have a long position, while the seller of the option (the writer) is said to have a short position.

Option Trades

Call Buyer (Long Position) Call Seller (Short Position)
Put Buyer (Long Position) Put Seller (Short Position)

Note that tradable options essentially amount to contracts between two parties. The companies whose securities underlie the option contracts are themselves not involved in the transactions, and cash flows between the various parties in the market. In any option trade, the counterparty may be another investor, or perhaps a market maker (a type of middle man offering to both buy and sell a particular security in the hopes of making a profit on the differing bid/ask prices).

In order to receive this right, the option buyer pays to the seller a certain amount of money, called the premium. The premium (the price of the option) depends on several things, including the price of the underlying shares, the volatility of the price movement of those underlying shares, and the amount of time left to expiration ("expiry").

What's a call option?

A call is the option to buy the underlying stock at a predetermined price (the strike price) by a predetermined date (the expiry). In American style options, the buyer of a call has the right to buy shares at the strike price until expiry. The seller of the call (also known as the call "writer") is the one with the obligation. If the call buyer decides to buy -- an act known as exercising the option -- the call writer must sell his/her shares to the call buyer at the strike price, regardless of what the actual price of the stock is at the time.

For more details, see call option.

What's a put option?

If a call is the right to buy, then perhaps unsurprisingly, a put is the right to sell the underlying stock at a predetermined strike price until a fixed expiry date. The put buyer has the right to sell shares at the strike price, and if he/she decides to sell, the put writer must buy at that price.

For more details, see put option.

Why use options?

A call buyer seeks to make a profit when the price of the underlying shares rises. The call price will rise as the shares do. The call writer is making the opposite bet, hoping for the stock price to decline or, at the very least, rise less than the amount received for selling the call in the first place.

The put buyer profits when the underlying stock price falls. A put increases in value as the underlying stock decreases in value. Conversely, put writers are hoping for the option to expire with the stock price above the strike price, or at least for the stock to decline an amount less than what they have been paid to sell the put.

We'll note here that relatively few options actually expire and see shares change hands. Options are, after all, tradable securities. As circumstances change, investors can lock in their profits (or losses) by buying (or selling) an opposite option contract to their original action.

Calls and puts, alone, or combined with each other, or even with positions in the underlying stock, can provide various levels of leverage or protection to a portfolio.

  • Option users can profit in bull, bear, or flat markets.
  • Options can act as insurance to protect gains in a stock that looks shaky.
  • They can be used to generate steady income from an underlying portfolio of blue-chip stocks.
  • Or they can be employed in an attempt to double or triple your money almost overnight.

But no matter how options are used, it's wise to always remember Robert A. Heinlein's acronym: TANSTAAFL (There Ain't No Such Thing As A Free Lunch). Insurance costs money -- money that comes out of your potential profits. Steady income comes at the cost of limiting the prospective upside of your investment. Seeking a quick double or treble has the accompanying risk of wiping out your investment in its entirety.

Option quotes

The first time you pull up an options quote can be overwhelming. There's considerable choice when it comes to the strike price and expiry month. Consider the following call option quotes for Apple (Nasdaq: AAPL), which sported a price of $91 at the time of the quotes.

Strike Price Symbol Last Price Bid Ask Open Interest
July 2007 Expiry
$85 QAAGQ $11.80 $11.60 $11.70 18,752
$90 QAAGR $8.70 $8.60 $8.70 16,789
$95 QAAGS $6.30 $6.20 $6.30 21,861
October 2007 Expiry
$85 QAAJQ $14.30 $14.30 $14.50 881
$90 QAAJR $11.30 $11.50 $11.70 2,237
$95 QAAJS $9.40 $9.10 $9.30 1,579

The first thing you'll notice is the plethora of option symbols, all for just one company! But fear not. It's really quite easy to decipher. An option symbol consists of three components:

Option symbol = base symbol + expiration month code + strike price code

The base symbol may be as many as three letters in length, and may be as simple as being the same as the general stock ticker. So, the base symbol for Ford is F, the base symbol for General Electric is GE, et cetera. Other companies, particularly those listed on the Nasdaq that may have tickers longer than three letters, are assigned base symbols that may or may not have any relation to the underlying stock's familiar ticker.

The expiration month code tells us, in a single letter, when the option expires and whether it's a call or a put. The letters "A" through "L" are assigned to call option, with "A" denoting a January expiry, "B" denoting February expiry, and so on. Letters "M" through "X" represent put options, "M" assigned to January, "N" to February, and so forth. Expiry takes place the third Friday of the associated expiration month.

The strike price codes are a little more complicated, given that stock prices themselves can be all over the map. At its simplest, "A" refers to a $5 strike, "B" a $10 strike, and so forth.

The highlighted call in the table has the symbol QAAGR, telling us that the base symbol for Apple options is "QAA," expiration month code is "G" and signifies July expiry, and the strike price code of "R" corresponds to a $90 strike price.

You'll also see three prices quoted. The "Last Price" is simply what it says it is -- the last traded price of the option. However, this last price may have been at a very different price than what the next transaction will occur at. Like any security, the "bid" price is what the counterparty is willing to buy the security for, and the "ask" price is what the counterparty is willing to sell the security for. With options, there can be substantially less liquidity in the market. Consequently, you definitely need to watch the bid-ask spread.

Stocks with a greater option volume and greater trading generally have a narrower spread. Those $90 Jul '07 Apple calls have a spread of 1.2% between bid and ask. The stock currently has its bid and ask only one penny apart, meaning the bid-ask spread is a minuscule 0.01%. And Apple has some pretty tight bid-ask spreads. Options on smaller companies can have positively murderous spreads -- 6%, 8%, or even 10% or more.

You'll note that call prices decline, while put prices rise, as the strike price on the option increases. This is as it should be. If IBM trades at $95, which call option would you anticipate as more valuable? The one letting you buy shares at $90 (which you could immediately turn around and sell in the market for a $5 profit), or the one letting you buy shares at $100 (which would cost you $5 more than what you would pay on the open market today)? Invoking the old "bird-in-the-hand" idiom, you'd happily pay more for the one that comes with the built-in profit. We'll get to option pricing in our next article.

Finally, know that options are sold in contracts for 100 shares. In buying that $90 Jul '07 Apple call, you're buying the right to purchase 100 shares of Apple for $90 each before the third Friday in July 2007, and paying $870 ($8.70 * 100) for the privilege.

The last column in the table shows the "Open Interest" on that particular option -- the net number of outstanding open contracts. An opening transaction occurs with an initial buy or sell of an option. A closing transaction takes place at a later date to offset the initial buy or sell. An investor who initially buys a put option adds to the open interest. If the investor later sells that put option to close out his position, it subtracts from open interest. Generally, we don't worry too much about open interest, with one exception -- if you're dealing in options where the open interest is only a few hundred contracts, it signifies that low liquidity I mentioned, likely leading to a wide bid-ask spread.

Exercise and assignment

Exercising an option simply means that the buyer of the call or put invokes the right to buy or sell the underlying stock at the strike price. When the option buyer (or holder) decides to exercise, the writer of the option is assigned an obligation to fulfill the terms of the contract. The hypothetical writer of that $90 July Apple call must deliver 100 shares, receiving $9,000 in return.

The mechanics of matching an exercising option holder with an assigned option writer is handled behind the scenes by the options clearing corporation. But once assigned, the writer must fulfill his/her end of the bargain, either delivering shares already owned, buying shares on the open market, or shorting shares and delivering those in fulfillment of the contract (of course, the writer then has the obligation to go back at some point and cover the short).

Know, too, that exercise at expiry is generally automatic and handled by the options clearing corporation, but again recall that most option traders close out their positions with offsetting contracts prior to expiry -- unless expiry happens to be advantageous to the trader.

European or American?

You may occasionally hear the terms "European" or "American" style options thrown around. These terms don't refer to geography, but simply denote differences in the stipulations attached to the options. A European option is one that can only be exercised at expiry and not before. An American option is one that can be exercised at any time right up to expiry. Traded options that you'll find quoted are American in nature, although you'll find that early exercise of such an option usually doesn't make a lot of sense (as for why, that topic's coming).

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