Considering my reluctance to sell any stock (or asset) that finds its way into my portfolio, you may wonder what use I have with options. I will spend a few sentences here explaining options and how I use them. Please keep in mind that I do not use options to any significant degree and that my knowledge and use of them is rudimentary at best. In addition, this is how I'm comfortable with using options. It is definitely not the only way to use them.
An option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular stock at a later day at an agreed price. In return for granting the option, the seller collects a payment (called a premium) from the buyer.
A ‘call’ option contract gives the buyer the right to buy the stock; a ‘put’ option gives the buyer of the option the right to sell a stock.
Option contracts are reconciled on the 3rd Friday of every month (stocks get bought/sold, etc.).
There are many types of options including stock, commodity, bond, index and futures but this is beyond the scope of this article. If you want to learn more about options including pricing models, types, and historical uses simply buy an option textbook. I'm sure that you'll find it as engrossing as I did.
This is a good time for an example.
As I mentioned before there are two types of options, call options and put options. I want to focus on the call option - or the option that gives the right to buy a stock.
Let us say that we purchase 1 call option contract for $2.00 on Fossil stock in Jan 2009 at a strike (execution) price of $15 per share that expires in Jun 2009. Let us further assume that the price of Fossil stock stands at $14 per share on Jan 2009.
Each option contract represents 100 shares of Fossil stock (10 option contracts represent 1,000 shares, 100 option contracts represent 10,000 shares, and so on and so forth).
Since we are buying 1 call option contract, we pay the seller $2.00 per share in premium or $200 ($2.00 per share x 100 shares).
For simplicity's sake let us assume that the person who sold me this contract is holding 100 shares of Fossil stock. Who is this seller? How did I find him? The short answer to this question is that I didn't. The discount brokerage found him, somewhere somehow in the sea of the market, wanting to sell 1 call option contract at $15 per share on Fossil stock that expires in Jun 2009.
From our (buyers) point of view, we paid $200 to control 100 shares of Fossil stock. When buying (or selling) an option contract we don't own the stock. In contrast, we could also control 100 shares of Fossil stock if we purchased 100 shares @ $15 per share, which would cost us $1,500. In the second case, we would own the stock.
If the conditions in the contract are met (i.e. Fossil stock soars to $15+ on or before the 3rd Friday of June 2009), we (the buyer) will be asked to put up the money to buy 100 shares of Fossil stock at $15 per share, or $1500. Our total cost if this were to come to pass would be $1700 ($1500 for the stock and the $200 we spent on the contract). This transaction (where the premium is deposited into the seller's account, and the stock is assigned to us) all happens instantaneously and automatically. There is no confirmation or further action necessary on our part.
Why would somebody want to spend $200 to do this? The buyer of the call option would do this because they believe that $14 per share for Fossil stock is low. In fact, they feel that Fossil stock should be far above $17 per share. Since the upside is technically 'infinite' the buyer of the call option would make a profit once the price per share rises above $17 ($15 per share for the cost to buy stock + the $2 premium paid to the seller).
The seller of the call option feels that the stock is overpriced at any price over $15 and is willing to limit their upside gain in return for $2 per share premium.
Why doesn't the buyer just buy Fossil stock at $14 per share if they believe that Fossil should be far above $17? They do this because they're not sure. If they purchased 100 shares of Fossil stock at $14 it would cost them $1400 and if they were wrong, they could potentially lose a lot of money. By paying a $2 per share option premium to the seller, they would effectively control the stock without spending $1400. If they were wrong and the stock moved sideways or down, they would only be out-of-pocket by $2 per share or $200.
Why would the seller sell a call option to a buyer? Why don’t they just sell the stock at $14 and be done with it? They do this because they’re not sure. If they sold the stock at $14 and the stock ran up to $15, the seller would lose out on $1 per share. By selling a call contract the seller would receive $1700 ($1500 for selling 100 stock + $200 premium received from the call option buyer). If the stock moves downwards or sideways, they would get to pocket the $200 (minus taxes) for nothing.
During a call option transaction one person (the buyer) is buying the right to buy and the other person (the seller) is selling the right to buy.
Conversely the opposite also exists: put options are the right to sell. One person (the buyer) can buy the right to sell and the other person (the seller) will sell the right to sell.
What is the point of all this?
As some of you know, I only buy stock when it is selling at less than 10x earnings or less than 2x book. Unless the stock market is in turmoil, this criteria is rarely met. However, if the price is floating slightly above this amount (say 11x earnings or 2.2x book) then I may start to write (sell) put option contracts on the stock at a (lower) price that represents 10x earnings and 2x book to collect premium income while I wait for my price! Often, this premium can be anywhere from $0.50 per share to $2.00 per share depending on the expiry of the contract.
For example, I could write 10 put option contracts and immediately collect a $500 to $2000 (minus commissions, taxes, etc.) today while I waited for my price. Now, if the price fell to 10x earnings and 2x book I would be required to put up more money to actually buy the stock, but keep in mind that I wanted to buy the stock at 10x earnings and 2x book anwyay! Also, if I became required to buy the stock, my purchase would have been subsidized by the premium that I had already received!
I hope this helps.
Best regards.
An option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular stock at a later day at an agreed price. In return for granting the option, the seller collects a payment (called a premium) from the buyer.
A ‘call’ option contract gives the buyer the right to buy the stock; a ‘put’ option gives the buyer of the option the right to sell a stock.
Option contracts are reconciled on the 3rd Friday of every month (stocks get bought/sold, etc.).
There are many types of options including stock, commodity, bond, index and futures but this is beyond the scope of this article. If you want to learn more about options including pricing models, types, and historical uses simply buy an option textbook. I'm sure that you'll find it as engrossing as I did.
This is a good time for an example.
As I mentioned before there are two types of options, call options and put options. I want to focus on the call option - or the option that gives the right to buy a stock.
Let us say that we purchase 1 call option contract for $2.00 on Fossil stock in Jan 2009 at a strike (execution) price of $15 per share that expires in Jun 2009. Let us further assume that the price of Fossil stock stands at $14 per share on Jan 2009.
Each option contract represents 100 shares of Fossil stock (10 option contracts represent 1,000 shares, 100 option contracts represent 10,000 shares, and so on and so forth).
Since we are buying 1 call option contract, we pay the seller $2.00 per share in premium or $200 ($2.00 per share x 100 shares).
For simplicity's sake let us assume that the person who sold me this contract is holding 100 shares of Fossil stock. Who is this seller? How did I find him? The short answer to this question is that I didn't. The discount brokerage found him, somewhere somehow in the sea of the market, wanting to sell 1 call option contract at $15 per share on Fossil stock that expires in Jun 2009.
From our (buyers) point of view, we paid $200 to control 100 shares of Fossil stock. When buying (or selling) an option contract we don't own the stock. In contrast, we could also control 100 shares of Fossil stock if we purchased 100 shares @ $15 per share, which would cost us $1,500. In the second case, we would own the stock.
If the conditions in the contract are met (i.e. Fossil stock soars to $15+ on or before the 3rd Friday of June 2009), we (the buyer) will be asked to put up the money to buy 100 shares of Fossil stock at $15 per share, or $1500. Our total cost if this were to come to pass would be $1700 ($1500 for the stock and the $200 we spent on the contract). This transaction (where the premium is deposited into the seller's account, and the stock is assigned to us) all happens instantaneously and automatically. There is no confirmation or further action necessary on our part.
Why would somebody want to spend $200 to do this? The buyer of the call option would do this because they believe that $14 per share for Fossil stock is low. In fact, they feel that Fossil stock should be far above $17 per share. Since the upside is technically 'infinite' the buyer of the call option would make a profit once the price per share rises above $17 ($15 per share for the cost to buy stock + the $2 premium paid to the seller).
The seller of the call option feels that the stock is overpriced at any price over $15 and is willing to limit their upside gain in return for $2 per share premium.
Why doesn't the buyer just buy Fossil stock at $14 per share if they believe that Fossil should be far above $17? They do this because they're not sure. If they purchased 100 shares of Fossil stock at $14 it would cost them $1400 and if they were wrong, they could potentially lose a lot of money. By paying a $2 per share option premium to the seller, they would effectively control the stock without spending $1400. If they were wrong and the stock moved sideways or down, they would only be out-of-pocket by $2 per share or $200.
Why would the seller sell a call option to a buyer? Why don’t they just sell the stock at $14 and be done with it? They do this because they’re not sure. If they sold the stock at $14 and the stock ran up to $15, the seller would lose out on $1 per share. By selling a call contract the seller would receive $1700 ($1500 for selling 100 stock + $200 premium received from the call option buyer). If the stock moves downwards or sideways, they would get to pocket the $200 (minus taxes) for nothing.
During a call option transaction one person (the buyer) is buying the right to buy and the other person (the seller) is selling the right to buy.
Conversely the opposite also exists: put options are the right to sell. One person (the buyer) can buy the right to sell and the other person (the seller) will sell the right to sell.
What is the point of all this?
As some of you know, I only buy stock when it is selling at less than 10x earnings or less than 2x book. Unless the stock market is in turmoil, this criteria is rarely met. However, if the price is floating slightly above this amount (say 11x earnings or 2.2x book) then I may start to write (sell) put option contracts on the stock at a (lower) price that represents 10x earnings and 2x book to collect premium income while I wait for my price! Often, this premium can be anywhere from $0.50 per share to $2.00 per share depending on the expiry of the contract.
For example, I could write 10 put option contracts and immediately collect a $500 to $2000 (minus commissions, taxes, etc.) today while I waited for my price. Now, if the price fell to 10x earnings and 2x book I would be required to put up more money to actually buy the stock, but keep in mind that I wanted to buy the stock at 10x earnings and 2x book anwyay! Also, if I became required to buy the stock, my purchase would have been subsidized by the premium that I had already received!
I hope this helps.
Best regards.
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