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Understanding Options Contracts: Leverage and Risk Management

Learn about options contracts and how they allow investors to leverage their capital and manage risk. Discover the two main types of options: call options and put options.

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Understanding Options Contracts: Leverage and Risk Management

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  1. CHAPTER15 Stock Options At a very exclusive party, a high-class, finely-clad woman slinked up to the CEO of a Fortune 500 company and said, “I will do anything – anything you want.” The CEO flatly responded, “Re-price my options.” Chapter Sections: Options on Common Stocks The Options Clearing Corporation Why Options? Stock Index Options Option Intrinsic Values and “Moneyness” Option Payoffs and Profits Using Options to Manage Risk Option Trading Strategies Arbitrage and Option Pricing Bounds Put-Call Parity

  2. What is an Option Contract? • A security that gives the holder the right to buy or sell a certain amount of an underlying financial asset at a specified price for a specified period of time • Financial asset examples: Stocks, bonds, etc. • Options contracts are not investments • They are contracts between two investors • Buyer of the option contract gets the right to buy (or sell) the financial asset at a given price for a given period of time • Seller of the option contract must buy (or sell) the asset according to the terms of the contract

  3. What is an Option Contract? (continued) • Options contracts are part of a class of securities called derivatives • Derivatives are securities that derive their value from the price behavior of an underlying real or financial asset • Options contracts have no voting rights, receive no dividends nor interest, and eventually expire • Their value comes from the fact that they allow the holder of the option to participate in the price behavior of the underlying asset • With a much lower capital outlay By the way, options contracts are usually just referred to as options.

  4. What is an Option Contract? (continued) • Options allow an investor to leverage their outlay of capital • Leverage – the ability to obtain a given equity position at a reduced capital investment, thereby magnifying returns (review) • With options, you can make the same amount of money from a stock or other security as if you bought it for full price • But only come up 1/10th or less of the money Sounds too good to be true, huh? Well, you are right. It is too good to be true. Much of the time, you lose the entire outlay. Options have a time limit. Most options expire worthless.

  5. What is the Rational for Options? • Instead of buying a stock, buy an option to buy a stock (or an option to sell a stock) • If the stock goes up, your option will go up (almost always much, much faster) and you can sell the option for a handsome profit • There is only one catch – The option expires in three, six or nine months • If the stock does not go up, the option is worthless • Most options expire worthless (Surprise!) • There are some scenarios where options can be worthwhile but they are few and far between!

  6. Option Contracts Example • Stock currently selling for $20 • You buy a share of the stock for $20 • If it goes up to $30, you have earned $10 on a $20 investment • You buy an option to purchase a share of the stock at $20 currently selling at $20 • It might only cost you $1 for the option • If the stock goes up to $30, your option price will probably go up to around $11 • You have earned $10 on a $1 investment • That is “leverage” in action • Congratulations! Pat yourself on the back!

  7. Option Contracts Example (continued) • But what if the stock price stays at $20 • Your option expires worthless at the end of three, six, or nine months • And, of course, after your option expires, the stock price zooms to $40 • You were so sure that this stock was going to hit the big time and you were absolutely right • But because you bought an option that expired, you lost the ability to share in the success of the stock My advice? Forget about the option and just buy the stock! But since this is an Intro to Investments class, we need to become proficient in the concepts, terms, and techniques of options. So…

  8. Two Main Types of Options • Call Option Contract – a.k.a. “Call” • A negotiable instrument that gives the buyer of the option the right to buy the underlying security at a stated price within a certain period of time • (The previous example was a “call” option) • When people talk about options, they are usually talking about call options • Put Option Contract – a.k.a. “Put” • A negotiable instrument that gives the buyer of the option the right to sell the underlying security at a stated price within a certain period of time • Opposite of a call option

  9. Two Main Types of Options (continued) • “Where did the terms ‘call’ and ‘put’ come from and how will I remember which is which?” • The term “call” comes from the idea that when you buy a call option, you get the right to “call the stock away” from the seller of the option • The term “put” comes from the idea that when you buy a put option, you get the right to “put the stock to” the seller of the option Get the idea? A “call” allows you to “call away the stock” from someone (buy it from them). A “put” allows you to “put the stock” to someone (sell it to them). Let us look at each in detail.

  10. The Two Parties of a Call Option • Buyer of the call option contract • The Call Option Buyer of the contract is the person who will do the “calling away” • They buy the right to “call the stock away from” (buy it from) the call seller • They do not have to exercise the right • In fact, often the options contract expires worthless • Seller of the call option contract • a.k.a. Option writer, Option maker • The Call Option Seller of the contract is the person who must sell the stock (“called away from”) • The call option seller is legally bound to sell the stock to the call buyer • In return, they get the option price from the call option buyer

  11. The Two Parties of a Call Option (continued) • “What is the Call Option Buyer Hoping For?” • The call option buyer is hoping that the price of the stock will go up – a call option buyer is bullish • If an option buyer has a call option to buy at $20 and the price goes to $30, the buyer can buy a $30 stock for only $20 • “What is the Call Option Seller Hoping For?” • The call option seller is hoping that the price of the stock will go down or stay the same – a call option seller is bearish (or at least not very bullish) • If the stock stays around $20 or goes down, the call option buyer will not want to exercise the option and it will expire worthless • And the call option seller gets to keep the price of the option

  12. Call Option Example Ed Ted $20 call price Pays $1 Gets $1 Call option buyer Call option seller Call Option Contract The call option buyer wants the price of the underlying stock to go up. He is bullish. No matter what happens to the price of the stock, he can buy it from (“call it away from”) the call option seller for $20. The call option seller wants the price of the underlying stock to go down. He is bearish. No matter what happens to the price of the stock, he must sell it to (“called away from”) the call option buyer for $20 if exercised. The call option contract is tied to the underlying stock. It will vary up & down as the stock varies.

  13. The Two Parties of a Put Option • Buyer of the put options contract • The Put Option Buyer of the contract is the person who will do the “putting to” • They buy the right to “put the stock to” (sell it to) the put option seller • Again, they do not have to exercise this right • Recall: Often the options contract expires worthless • Seller of the put options contract • a.k.a. Option writer, Option maker • The Put Option Seller of the contract is the person who must buy the stock (“put to”) • The put option seller is legally bound to buy the stock from the put option buyer • In return, they get the option price from the put option buyer

  14. The Two Parties of a Put Option (continued) • “What is the Put Option Buyer Hoping For?” • The put option buyer is hoping that the price of the stock will go down – a put option buyer is bearish • If an option buyer has a put option to sell at $20 and the price goes to $10, the buyer can sell the $10 stock (“put it to the option seller”) for $20 • “What is the Put Option Seller Hoping For?” • The put option seller is hoping that the price of the stock will go up or stay the same – a put option seller is bullish (or at least not very bearish) • If the stock stays around $20 or goes up, the put option buyer will not want to exercise the option and it will expire worthless • And the put option seller gets to keep the price of the option

  15. Put Option Example Fred Ned $20 put price Pays $1 Gets $1 Put option buyer Put option seller Put Option Contract The put option seller wants the price of the underlying stock to go up. He is bullish. No matter what happens to the price of the stock, he must buy it from (“put to”) the put option buyer for $20 if the option is exercised. The put option buyer wants the price of the underlying stock to go down. He is bearish. No matter what happens to the price of the stock, he can sell it to (“put it to”) the put option seller for $20. The put option contract is tied to the underlying stock. It will vary up & down as the stock varies.

  16. “Options are confusing, aren’t they?” In fact, the section on options is one of the hardest parts of the Series 7 Stockbroker exam “Options sound like gambling. I am right?” Yes. Options are a form of gambling. It is a zero-sum game. Someone wins, someone loses. A family acquaintance once called me. “Hey, Frank. I hear you can make a lot of money investing in options!” I said, “Wait a minute. Yes, you can make a lot of money; you can also lose a lot of money. But you can’t invest in options. You can speculate in options. You can not invest in something that has a 60% chance of being worthless in three months! That is not investing.” Time for Questions on Options

  17. Option Attributes • Strike Price – a.k.a. Exercise Price • The contract price between the buyer of an option and the seller of the option • The stated price at which you can buy a security with a call option or sell a security with a put option • Listed options traditionally sold in… • $2.50 increments for stocks selling for less than $25 • $5.00 increments for stocks selling between $25 & $200 • $10.00 increments for stocks selling for greater than $200 • But pricing is more flexible now • There are some stock options that sell in $1 increments

  18. Option Attributes (continued) • Expiration Date • The date at which an option expires • Listed options always expire at the close of the market on the third Friday of the month of the option’s expiration • The hour before close of the market on the third Friday is sometimes called the “witching hour” As well as stock options, there are also stock index options and stock index futures which we will discuss later. When all three – stock options, stock index options, and stock futures – expire on the same day, then it is called the “triple-witching hour.”

  19. Option Attributes (continued) • Exercise Style • American options • Can be exercised at any time before the expiration • European options • Can only be exercised at expiration Normally, if you wanted to take a profit from an option that had done well and there was still significant time until the expiration date, you would simply resell the option instead of actually exercising the option. However, with an American-style option, if you really wanted the stock, you could exercise the option and buy (or sell) the stock before the expiration date. By the way, there are several other types of options with various provisions.

  20. Quotations of Listed Options • Go online to www.marketwatch.com • Search for the stock and choose [Options] from the stock menu just above the quote data • You can still try finance.yahoo.com • When you are viewing the quote of a stock, choose the Options link on the left hand side of the screen • But lately, the quotes for options have been very unreliable • Yahoo! seems to be intent on destroying what is left of their once-fabulous Finance page. Oh, well … The list of available options contracts and their prices for a particular security is called an option chain.

  21. Options Contracts • Buying & Selling (writing, making) Options Contracts • We have discussed options contracts as if they were traded just as stocks are traded • In most ways, they are very similar • But there is one major difference • Options are sold as “contracts” • Each contract represents one hundred shares of underlying security • There are no odd-lots on the options exchanges So if the listed price of the option is $5, then one contract will cost $500 ($5 * 100 shares). Two contracts will cost $1,000, etc.

  22. Options Contracts (continued) • Option Premium • The quoted price the option buyer pays to buy a listed put or call option • The seller (a.k.a. writer, maker) receives the premium immediately and gets to keep it whether or not the option is ever exercised • (Did I mention that most options expire without being exercised? That most options expire worthless?) To make it more confusing, the term premium is also used in a more precise manner when valuing options. For this reason, most people always refer to the price of the option instead of the premium of the option.

  23. Valuations of Options • “In-the-money” Call Option • A call option with a strike price less than the market price of the underlying security • Example: Call Strike Price $50 • Market Price $54 • $4 “In-the-money” • “Out-of-the-money” Call Option • A call option with no real value because the strike price exceeds the market price of the stock • Example: Call Strike Price $50 • Market Price $47 • $3 “Out-of-the-money”

  24. Valuations of Options (continued) • “In-the-money” Put Option • A put option with a strike price greater than the market price of the underlying security • Example: Put Strike Price $50 • Market Price $46 • $4 “In-the-money” • “Out-of-the-money” Put Option • A put option with no real value because the market price exceeds the strike price of the stock • Example: Put Strike Price $50 • Market Price $52 • $2 “Out-of-the-money”

  25. Call Option Valuations of Options: Example • Call Option Example(Strike price $50, Option price $10) Theoretically, for every $1 above the strike price, the call buyer earns a dollar and the call seller (a.k.a. call writer) loses a $1.

  26. Call Option Valuations of Options: Example (continued) • Call Option Example(Strike price $50, Option price $10) But the previous graph ignored the price of the option. The call buyer had to pay $10 and the call seller received $10.

  27. Put Option Valuations of Options: Example (continued) • Put Option Example (Strike price $50, Option price $10) Again, theoretically, for every $1 below the strike price, the put buyer earns a dollar and the put seller (a.k.a. put writer) loses a $1.

  28. Put Option Valuations of Options: Example (continued) • Put Option Example (Strike price $50, Option price $10) But again, the previous graph ignored the fact the put buyer had to pay $10 for the option and the put seller (a.k.a. put writer) earned $10.

  29. Valuations of Options (continued) • Time Premium • The amount by which the option price exceeds the option’s “in-the-money” value • In general, the longer the time to expiration, the greater the size of the time premium • If an option is “out-of-the-money,” then the entire price of the option is due to the time premium In other words, an option that is “in-the-money” will sell for more than the amount it is “in-the-money” because of the time remaining until the expiration date. Often, an option that is “out- of-the-money” will still have time value. The option still has time to become worth more (as the underlying stock price changes).

  30. Commissions on Option Contracts • And Do Not Forget Commissions! • In the previous examples, we did not include the cost of the commissions • A commission is charged whenever an option is bought or sold • Both buyer and seller pay a commission • And a commission is charged when and if the buyer exercises the option and buys or sells the stock • Again, both buyer and seller pay a commission • When you include the commissions, it makes it that much harder to make money in options But if you are a broker, you would simply love to have your clients get hooked on options. P.S. None of my clients trade options. I would do my best to talk them out of it if they asked to!

  31. Option Strategies • Speculating – You will often hear… • “If you feel the market price of a particular stock is going to move up…” • “If you anticipate a drop in price within the next six months…” • “It is a highly risky investment strategy, but it may be suited for the more speculatively inclined.” The flaw in these arguments is this: There has never been a successful method to predict stock prices in the short term. You may “feel” or “anticipate” that the price will go up or down, but that does not mean that it will. It is not investing, it is gambling. Plus, you may be correct but your option may expire before you are proven correct.

  32. Option Strategies (continued) • Hedging • A transaction or series of transactions made to reduce the risk of adverse price movements in an asset • Hedging can be thought of as insurance • And although insurance can be useful in some circumstances, it is not free • You pay for the insurance via the price of the option and the commissions Investors can use hedging strategies when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the option and the commissions).

  33. Option Strategies (continued) • Hedging Example • You own 100 shares of Butterfly.com and it is currently selling for $50 • You are afraid the price will plummet within the next 3 months to $10 • You purchase a put at $50 • No matter what happens, you can sell the stock for $50 … but only until the option expires • Then you must go out and buy more insurance • This is called a “protective put” Insurance is not free. Using options as insurance is one way to keep your broker very happy. If you are sure the stock will fall, why not just sell the darned thing?

  34. Option Strategies (continued) • Straddle • The simultaneous purchase (or sale) of a put and a call on the same underlying financial asset • If the price is volatile in either direction, up or down, you will make money (providing you pass the break-even point for both purchases plus the commissions) • If the stock price is not volatile, you would sell (a.k.a. write, make) the straddle and hope that the price does not change greatly Two commissions at the same time! Your broker is gonna’ really love you!

  35. Option Strategies (continued) • Straddle Example • Butterfly.com is selling for $50 but its price is extremely volatile • You purchase a call for $50 and a put for $50 • The price of the call option is $4 and the price of the put option is $5 • Now, no matter which way the price goes, one of your options will be in-the-money But the call cost you $4 and the put cost you $5, so the price has to move at least $9 either way before you break-even. And we did not include the cost of the commissions. You paid two commissions for the straddle and possibly one more for exercising the option. Brilliant strategy, huh? Wait, it gets better.

  36. Option Strategies (continued) • Spread • The simultaneous purchase and/or sale of two or more options with different strike prices and/or expiration dates • Example: Stock selling for $50 • Buy a call at a strike price of $50 • Sell a call at a strike price of $55 • You paid for the call at $50, you got paid for the call at $55 • If the stock price rises, you make money The possibilities are endless. And so are the commissions.

  37. Option Strategies (continued) • Selling Options – a.k.a. Writing Options, Making Options • Selling options allows the individual investor to play the part of the casino • You become the Las Vegas casino and the option buyers are betting against you • “More often than not, the option writer is right.” • Most options expire worthless • Have I mentioned this yet? • No matter what happens, the option seller gets the buyer’s premium – the price of the option If and when I ever begin trading options, it will be as an option writer. But that does not mean you still can not lose big.

  38. Option Strategies (continued) • Selling Options (continued) • Covered Options • Options written against stock owned (or sold short) by the writer • Naked Options – a.k.a. Uncovered Options • Options written on securities not owned (or sold short) by the writer The amount of return to the option writer is always limited to the amount of option premium received. But the loss can be substantial, even unlimited in the case of a naked call, a.k.a. uncovered call.

  39. Option Strategies (continued) • Selling Options (continued) • Covered Call • You own a stock and you are considering selling • You write a covered call and receive the premium • If the stock price jumps substantially, the stock will be called away from you (You will be forced to sell) • If the stock price stays the same or goes down, the option will expire worthless • And you can then write another covered call • In either case, you get to keep the premium This strategy is only one of two option strategies I personally would ever consider.

  40. Option Strategies (continued) • Selling Options (continued) • Covered Call Example • You own Butterfly.com and it is currently selling for $50 a share – You bought it at $40 and want to sell • You write a covered call at $55 and receive $500 since the premium for a $55 call is currently $5 • If the stock price jumps over $55, it will be called away from you at $55 • It is as if you actually sold it for $60 ( $55 + $5 ) • If the stock prices stays below $55, you can write another covered call This strategy allows you to make extra money from a stock that you already own. Do you see any disadvantages?

  41. Option Strategies (continued) • Selling Options (continued) • Naked Put • You are considering purchasing a stock and you have the cash to make the transaction • You write a naked put and receive the premium • If the stock price falls substantially, the stock will be put to you (you will have to purchase it) • If the stock price stays the same or goes up, the option will expire worthless • And you can then write another naked put • In either case, you get to keep the premium This is the only other option strategy that I would personally consider.

  42. Option Strategies (continued) • Selling Options (continued) • Naked Put Example • You are considering purchasing Butterfly.com and it is currently selling for $50 and you have the cash • You write a naked put at $45 and receive a $300 premium since the cost of a $45 put is currently $3 • If the stock price falls below $45, the stock will be put to you at $45 • It is as if you bought it at $42 ( $45 - $3 ) • If the stock price stays the same or goes up, you can write another naked put This strategy allows you to make extra money from a stock that you want to purchase. Do you see any disadvantages?

  43. Employee Stock Options • Employee Stock Options (a.k.a. ESOs) • An option granted to an employee by a company giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time • Usually have some significant differences from normal call options • Cannot be sold • Expire in many years (up to 10 years) • Usually have a vesting period (typically 3 to 7 years) • If you leave before the vesting period is over, you lose your stock options During the tech boom of the late 1990’s, ESOs were used extensively to attract employees to start-up companies.

  44. Employee Stock Options (continued) • Employee Stock Options (a.k.a. ESOs) • During the 2000-2002 bear market, ESOs were the subject of much controversy • There is still some fall-out and publicity as companies and the SEC continue to wrangle over how and even if they should be used • Currently, companies can give ESOs to their employees and not have to pay anything • They do not reduce the company’s earnings • Many companies have agreed to expense stock options • Unfortunately, how do you come up with a price for something that is currently worthless?

  45. Employee Stock Options (continued) • Employee Stock Options (a.k.a. ESOs) • To make matters worse, while some people became fabulously wealthy through ESOs during the Internet mania, • Example: John Moores of Padres & Peregrine fame • Many other people were socked with crippling tax burdens on worthless pieces of paper when their companies collapsed! • How can that be, you ask? • The AMT (Alternative Minimum Tax) does not care if you never exercise the options • You still owe the tax on the paper gain • Even if you never were able to realize the gain – Bizarre!

  46. Valuations of Options –Revisited • “Wait a minute. Did you ask, ‘How do you come up with a price for something that is currently worthless?’” • Yes, that is correct. Since many ESOs are “out-of-the-money”, often by a large amount, or can not be exercised for a long time, or both, how does the company put a price on it? • The financial world currently uses a system called the Black-Shoales Option Pricing Model • It may sound impressive, but it is really very silly • In my humble opinion… Chapter 16 is devoted to the Black-Shoales model. We are going to ignore it, if you do not mind.

  47. Valuations of Options –Revisited • Example: The Black-Shoales Option Pricing Model • Stock currently selling for $7.50 per share • Employee stock option has an exercise price of $10 • It is currently “out-of-the-money” • Plus the option can not be exercised for 3 years • The Black-Shoales model might say that the employee stock option is worth $2.50 Huh? You can not sell it. You can not exercise it for 3 years. It is “out-of-the-money.” How is it worth $2.50? The stock price might never go over $10. And if you are unfortunate enough to be affected by the AMT, you might have to pay taxes on it!

  48. Stock-Index Options • A put or call option written on a specific stock market index, such as the S&P 500 • A stock-index option allows an investor to purchase or sell an option that responds to a stock market index • Can hedge a portfolio by purchasing a put on a stock-index option that represents the portfolio • Acts as insurance against a large loss (until it expires) • Over 75 indices represented • Large, mid, small cap stocks • Domestic, international, regional, country-specific Whether speculating or hedging, it is still risky and expensive.

  49. Other Types of Options • Interest Rate Options • Put and call options written on fixed-income securities such as bonds • Currency Options • Put and call options written on foreign currencies • Can be an important tool for foreign investors and multi-national corporations who must periodically convert U. S. Dollars to and from other currencies • LEAPS • Long-term Equity Anticipation Securities • Long-term options – 9 months to 3 years (?)

  50. Warrants • A long-lived option that gives the holder the right to buy stock in a company at a price specified on the warrant • Warrants are usually issued by the same company that issues the underlying stock • Often as accompanying securities to bonds • Or as compensation to employees (like ESOs) • Unlike options where each contract represents 100 shares of stock, one warrant represents the right to buy one share of stock • Warrants are always call options • There are no put warrants

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