OPTIONS
An option is a contract where the seller/writer of an option is under an obligation to perform a purchase (put) or sale (call) of a security if the owner (long) requires him to do so- though it is not necessary that the owner of the contract do anything.
An uncovered option seller is one that does not own the security (call option) or have the money (put) in his account.
Call Option
With a call option, the seller hopes that the stock goes down- or at least does nothing. The buyer (long position) hopes that the stock reaches at least the strike price and preferably higher. He then has the right to pay the seller the amount of the strike price for 100 shares of the stock and subsequently sell the stock in the open market for more. Of course he must also adjust the profit for the premium paid to buy the option.
Most options expire worthless, but at least the buyer has reduced his exposure in dollars invested since it would have cost considerably more to buy the stock outright.
Most options are not exercised but sold to other option investors.
CMV- Current Market Value
Strike Price- price that the stock must reach before it is profitable for the owner to exercise the option.
Exercise- Pay the seller the strike price indicated in the option contract and receive 100 shares of the stock
Premium- amount required by seller to be paid for contract. Varies as to CMV, length of option, volatility of underlying stock.
| Has Obligations | Has Rights |
| Short/Seller/Writer of call contract | Long/Owner of call contract |
Strike Price = $55
(Current Market Value) CMV = $50.00
| Writer is paid $200 premium by | Owner of option |
Assume price goes to $60
| Writer is paid $5,500 by | Option owner |
| Writer gives 100 shares of stock to | Option owner |
| Option owner sells 100 shares for total of $6,000. Profit is $6,000- $5,500- $200 premium = $300. |
If the writer of the contract already owns the stock, they are called covered writers. This is generally considered a fairly conservative approach to generating more income for the writers since most calls are never exercised. Note however that if the stock actually does rise, the writer may be called upon to deliver/sell the stock thereby losing any potential future gain. Further, any appreciation to that point now becomes taxable. Or, in the alternative, the writer will need to buy back the option at a much higher price if they wished to hold the stock.
If the stock starts to drop, part of the loss is offset by the premium for the call. That said, if the stock really plummets, the offset will provide little or no security from a significant loss.
As such, the conservative element is reflective of a relatively stable stock price. If the price varies substantially, the option may provide little comfort for the investor.
If the stock is NOT owned, they are uncovered calls and there is a substantial risk involved. The writer may be called upon to deliver stock at the exercise price regardless of how high the stock may have already appreciated to. In the above example, the writer may have to pay $60 or $70 or $100 per share if he has to deliver the stock to the option holder. And he will only be paid the strike price per contract- $60.00.
Buyers of options are able to "play" the market with considerable leverage. But there aren't that many stocks that exceed the strike price PLUS the premium so that the owner at least breaks even.
Owners of options do not have to hold them to maturity. They may sell them to others at any time.
Most people are familiar with options on stocks. However, options may be
placed on just about anything including the many market indexes such as the
S&P 500 Index.
Put Option
The seller hopes the stock will go up- or at least no place. The owner hopes that the stock will go down. In such case, the owner of the option has to right to force the seller to buy stock at the strike price.
| Obligations | Rights |
| Short/Seller/Writer of Put contract | Long/Owner of put contract |
Strike Price = $45
(Current Market Value) CMV = $50.00
| Writer is paid $100 premium by | Owner of option |
Assume price goes to $15
| Option owner goes out and buys 100 shares of stock for $1,500 | |
| Writer is given 100 shares of stock and must pay the strike price of $45 per share to owner | Option owner receives $4,500 |
| Option owner nets $4,500- $1,500- $100 premium= $2,900 |
Put options are possible hedges of a stock value potentially going down and are particularly useful where the underlying stock has a low basis.
There are many, many variations of options where various calls and puts can be bought and sold together and can become quite complex. The comments above will give the investor insight to the basics. HOwever, much more effort must be considered before use.