While many of you may be familiar with stock options from grants given by your employer, there are also "tradeable options" that are listed on the exchanges, which can be bought and sold daily. This month we will explore that a bit deeper.
Commonly referred to as a "derivative", an option is a tradeable instrument which gives the owner the "right" to buy or sell a security, commodity or index at a specific price - by a specific date. Is that confusing? Let's break it down with an example:
In the graphic below you will see the June options for Coca-Cola. When I took this screen shot Coke stock was trading at $76.68 (on the graphic under the column titled "strike").
A Call Option gives the buyer the "right" to purchase the stock for the "strike" price before the expiration date of the Option. In this example of the June 2012 Options, a buyer wanting the right to buy Coke at $77.50 per share in June could pay $.84/share (look at the Bid / Ask columns and line up with the $77.50 strike price row) and have that right. The important thing to note is Options do expire on the 3rd Friday of each month. So if Coke was not at or above $77.50 on June 15th, the option is worthless.
A Put Option gives the buyer the "right" to SELL stock to someone at the "strike" price before the expiration date of the option. In the example above you could buy the right to sell Coke stock at $75 per share for approximately $.93/share. (go to Strike price column, go down to $75 and then go across that Row to the bid / ask columns for option price)
By now you may be wondering what is the purpose of an Option? If you want to buy or sell Coke stock, why not just trade the actual stock?
There are a couple of primary uses for Options: Speculation, Hedging and Income. So let's explore:
Speculation: If you are a trader and feel that a stock is going to move higher or move lower, you could purchase that stock (or short sell the stock). With Coke the trader would need $76,680 to buy 1000 shares if they thought it would go higher. However, they could buy 10 of the $77.50 June Calls (equivalent to 1000 shares) for $840. If the stock moved higher in the near term the trader could make his money without tying up a lot of capital. This applies the same way for a trader that thinks the stock will go lower, he can buy the PUT options and profit if that stock drops.
Hedging/Income: these sort of work the same. Hedging would be "buying" insurance on your stock portfolio by purchasing PUT options. If you were holding stock and feared it might drop in price you could buy the PUT option and hedge your account. On the flipside if you were holding stock and wanted to generate some income as you thought it would trade sideways or correct a little, you could sell a CALL Option and generate some income. You as the seller get to take in the proceeds of selling the CALL option but give the buyer the right to purchase the stock from you on or before expiration. So you always run the risk of having the stock "called" away from you at the strike price.
Without going into a lot of detail, Option prices are made up of an Intrinsic Value and Time Value. The closer you get to the monthly expiration, the more rapidly the "time value" premium of an options price drops. (In the case of Coke $77.50 CALL option above, it is all Time Value premium until the stocks actual price gets above that level) It has been estimated that up to 80% of Options expire worthless, so keep that in mind if you get the urge to speculate by trading options. You can lose money fairly quickly.