For the benefit of a broad audience, I wanted to take a moment to create a baseline for how options work and cover the main terminology.
I’m sure investors of all levels will benefit from this exercise.
What is critically important to know is that an option is a security that conveys the right (but not the obligation) to buy or sell a specific security at an agreed price within a set period of time.
Every option is identified with a specific stock (or in some cases an entire index of stocks — you can buy options on the S&P 500 for instance).
So whenever you place an options trade, the movement of the underlying stock will affect the success or failure of your investment.
Options come in two standard varieties: Calls and puts.
Options trade in lots of 100 shares. One “contract” = 100 shares.
One call option gives you the right (but not the obligation) to buy 100 shares of a particular underlying stock at a specific price (the exercise price or strike price) before a specified date in the future (the expiration date).
One put option conveys the right (but not the obligation) to sell 100 shares of a stock at the strike price by the time the put option expires.
All options have expiration dates. It’s usually a matter of weeks or months. But LEAPS are long-dated options with expirations lasting from one to three years. LEAPS is an acronym that stands for Long Term Equity Anticipation Security.
When you buy an option, it is as though someone is saying to you, “I will allow you to buy or sell 100 shares of this company’s stock, at a specified price per share, at any time between now and the expiration date.”
And it’s further understood that, “For that right, I expect you to pay me a fee.”
That fee is called a premium. The amount of the premium will vary considerably depending on the exercise price and time until expiration, as well as the stock’s volatility.
Let’s get a little more granular on what affects the price of an option…
An option has two sources of value. The cost (or premium) of any given option is based on its “intrinsic value” and its “time value.”
Intrinsic value is the portion of the option premium that is “in the money.” Any additional value beyond that is considered time value.
Let’s say a call option has a premium of $3 per share and a strike price of $45.
At the time you buy the call, if the underlying stock’s market value is $46 per share, then we say the following about the option’s “intrinsic value” and “time value”:
- This option has one point of intrinsic value. In other words, the option’s strike price is $1 “in the money” — i.e., the strike price is $1 below the price of the stock.
- That leaves two points (the $3 premium minus the intrinsic value of $1) for the time value.
If the stock’s price stays the same (leaving the intrinsic value at $1), as the option approaches expiration, the option’s time value shrinks — decreasing the amount of the premium.
At expiration, the time value will equal zero, leaving the premium value equal to the intrinsic value – in this case: $1.
All options act the same when it comes to intrinsic value.
For example, if a call option is in the money by $5 (the option’s strike price is $35 and the current price of the stock is $40), then the option premium will reflect $5 of intrinsic value, plus some additional amount for the option’s time value.
If the call option moves $10 into the money, the option premium will reflect at least $10 of intrinsic value, plus some additional amount for the option’s time value.
Conversely, if the stock declines, and the option moves out of the money. For example, if the option’s strike price is $35 and the underlying stock falls to $34, the intrinsic value goes to zero, and the premium would only reflect time value.
As you can see, the primary risk of options is their finite time value. They are like burning matches. Traders call this trait “time decay”.
Because options expire, they behave very differently than stocks do. If you own a stock, your investment timeframe can be open-ended. Not so with options.
With options, not only do you have to be correct about the direction of the underlying stock, but the movement you foresee also has to take place within a specified timeframe.
Inevitably, some subscribers may ask: “Why bother with these things?”
The answer is that options are a powerful tool. They can do things a stock simply cannot do. And because of their unique attributes, options can boost a portfolio’s returns, while reducing risk.
In The Speculator, the option trades we recommend offer three advantages, relative to stock trades:
- The “price of admission” to a particular trade is lower. For example: buying call options on 1,000 shares of a stock costs much less than buying 1,000 shares of that stock outright.
- The second advantage of options is leverage. Leverage is crudely defined as “using a little money to make a lot.” But we’ll use a more conventional definition: “Putting down a small investment to control a large amount of stock.” Because option buying requires less upfront capital than purchasing (or shorting) the underlying stock, a winning trade will typically deliver a much larger return on capital than you’d earn from buying (or shorting) the stock.
- The last advantage of option trades is that they subject investors to a much smaller downside risk, compared to a stock. The buyer of a call option, for example, cannot lose more than the cost of the option, no matter how far the underlying stock might fall.
If you are interested in putting the options strategy of The Speculator to work for you, click here.