There are two primary types of options, call options and put options, and each can be bought or sold, resulting in four basic types of option trades. One option contract controls 100 shares of an underlying stock. Purchasing an option contract means the investor is “long” the contract, while selling a contract is a “short” position.
The holder of a call option (the buyer) has purchased the rights from the seller to all future price appreciation of the stock that underlies the option contract above a certain predetermined level (the exercise price) during the life of the contract. In exchange for this right, the seller of the call option receives an upfront cash payment from the buyer. The buyer of the call option believes the stock will appreciate significantly, and the contract allows them to benefit if they are correct by simply paying a contract premium as opposed to purchasing the underlying stock itself, which would require a greater capital outlay.
The holder of a put option has purchased the rights from the seller of the option to be able to sell the underlying stock at the exercise price of the contract even if the price of the stock falls significantly below that level. In exchange for this right, the seller of the put option received an upfront cash payment from the buyer. The buyer of the put option is concerned that a stock will decline and is effectively purchasing insurance against that risk.
Example: Call Options
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month’s time is being priced at $2. If an investor believes that the stock will rise sharply during the life of the contract, they could spend $200 to purchase a one call option contract. If the stock appreciates to $50 by contract expiration, the option would now be worth $10, resulting in an $800 gain on the initial $200 investment. Long call options provide unlimited upside potential, but the buyer risks losing their entire premium if the stock does not trade above the exercise price at expiration.
The investor who sold the call option in this example generated an immediate cash flow of $200 ($2 per share). If the stock is trading above $40 at the expiration of the call option, the option will be exercised by the buyer, and the seller will be required to deliver cash or shares in order tosatisfy the obligation. If the stock has traded significantly above $40 and the seller does not own shares in the underlying company, the potential cash outlay to settle the contract could be significantly larger than the original $200 premium received (theoretically, the seller could owe an infinite amount to the buyer if they do not own the underlying stock to deliver shares).
Example: Put Options
Suppose an investor owns a stock trading at $40 per share, but he or she is concerned that its price may decline. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. By purchasing the put option for $200, the investor is effectively insuring against any price declines for the position low $40. If the stock were to decline to $30 during the life of the contract, the option will increase in value at expiration to $1,000, providing a hedge against the stock price decline.
Long put options provide guaranteed protection against a decline in a stock below the contract’s exercise price, but the buyer risks losing their entire premium if the stock does not trade below the exercise price at expiration.
The investor who sold the put option in this example generated an immediate cash flow of $200 ($2 per share). If the stock is trading below $40 at the expiration of the put option, the option will be exercised by the buyer, and the seller will be required to purchase the shares at the contract price even if they are trading significantly lower at the time of contract expiration.
Incorporating Options into an Overall Portfolio
An investor can use options to express an opinion on a stock directly and specifically. For example, without options, an investor must simply choose to own a stock or not based on their assessment of it as an attractive investment. However, incorporating options allows the investor to continuously express a thesis on a stock and potentially earn a profit no matter what the direction (or lack thereof) of the stock price (assuming the investor correctly predicts the range of the stock’s movements of course).
For example, let’s say hypothetically that an investor holds shares in a company that is trading for $50, and the investor, based on their analysis, would be comfortable selling the stock at $55. They may sell a call option at an exercise price of $55 and receive an immediate cash payment in order to commit to selling the stock at the price they already planned to sell at anyway. If the stock never trades above $55, the investor keeps both the shares and the cash payment, and the call option contract expires worthless for the buyer. This strategy is commonly referred to as “covered call writing” because the investor is selling (writing) a call option contract while holding shares to “cover” the contract’s obligation.
Example: Covered Call
Assume an investor purchases 100 shares of XYZ stock for $50, and immediately writes (sells) a one-month call option contract with an exercise price of $55 for $2 per share. The investor has spent $5,000 to purchase the shares and received $200 in a cash payment via the option premium by committing to sell the shares at $55 during the life of the call option contract even if the price rises above $55 per share.
On expiration date, if the stock had appreciated to $57, the option would be exercised, and the shares sold to the call option contract buyer for $55. The investor who sold the contract would have made a total profit of $700 after factoring in the $200 in premiums received for writing the call.
If the stock had declined to $45 per share during the contract, the shares would have lost $500, but the call option premium provided a $200 buffer against this loss as the contract would expire worthless to the buyer, and the seller keeps the option premium as well as the shares.
In another example, let’s assume an investor believes that a company is attractive fundamentally (e.g., well managed, healthy balance sheets, good products, definable competitive advantages), but the stock price is currently higher than the investor believes to be fair. In order to gain exposure to the stock and begin to accrue some potential return, the investor may sell a put option at a price he or she believes to be attractive. The investor is committing to buy the stock at a lower price for the duration of the put option contract, and they are receiving an immediately cash payment from the put option buyer in exchange for that obligation.
Example: Selling a Put Option
If XYZ stock is trading at $50, but an investor believes that a more fair price is $45. He or she may sell a put option contract with an exercise price of $45 and collect a $2 premium by committing to purchase the shares at $45 even if they fall below that price. If the shares decline to $40, the investor would incur a loss of $300 ($500 loss on the share price movement, offset by the $200 option premium received).
Option contracts provide investors with multiple avenues to express an opinion on a company, to potentially earn enhanced profits and reduce risk. Understanding the forces that drive their prices is an important component of successful options investing, which we will cover in greater detail in the subsequent article.
