Most of us either know someone or have at least heard of someone getting rich through company supplied stock options. But few people actually understand the pricing and mechanics of stock options, or how to effectively buy and sell them for profit. Options are complicated trading instruments that require sophisticated knowledge and experience to succeed with them. But if you are looking for enhanced yearly returns in the market of 30-50% or more, then you will need to learn more about options. This article is just a basic introduction, so if you like what you see, then be prepared to spend significant time and effort reading and learning more. And check out the geldpress bookstore for plenty of reading material to keep you moving in the right direction.

First the definition. From investopedia, an option is:

A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (excercise date).

The above definition can be broken down into:

  • the right but not the obligation (most option buyers just re-sell the original option as opposed to exercising the option and selling the stock)
  • to buy (call options) or sell (put options) a security or financial asset (100 shares of stock)
  • at an agreed-upon price (the strike price)
  • during a period of time (options generally expire on the 3rd Friday of every month).

But to really understand that definition, you need to look at an example. Today is July 9th, and the third Friday of July (options expiration day) is July 18th. There are 7 more trading days and one weekend left before expiration day. Take a look at the options chain below for Apple (symbol AAPL), and take note of the following:

  1. The current chain is for July options expiration (7 trading days left until expiration). Apple also (currently) has tradeable options for August and October of 2008, plus January 2009 and January 2010.
  2. Options come in two varieties - call options and put options. In the chart below, the call options are shown on the left and the put options are on the right.
  3. Options have unique trading symbols, just like stocks. The symbol for the July 2008 Apple option with a strike price of 175 is .APVGO. (Note: Depending on your broker, the syntax for entering options orders can be one of “.APVGO”, “-APVGO”, “APVGO”, or possibly others)
  4. Options have BID/ASK spreads just like stocks, but the spreads can be much larger with options as compared to stocks. When getting started in options, it is best to trade highly liquid and high volume positions where the options spreads are small (less then 20 cents between BID/ASK). The BID/ASK spread of the Apple July 175 as shown in the table below is 4.90 / 5.00.
  5. Just as with stocks, it is not always necessary to buy at the ask and sell at the bid. You can always try your luck with a limit order halfway between the BID and ASK spread.

Other details:

  • Contract size - An option contract always relates to 100 units of the underlying. So a July 175 apple contract would sell for approximately $4.95 * 100 = $495 (assuming our order was accepted at the midway point between the BID/ASK)
  • Intrinsic and extrinsic (time) value - option prices can either be in the money, when the stock price trades above the strike price, or out of the money, when the stock price trades lower then the strike price. For out of the money options, the value of an option is 100% extrinsic value. You can also refer to extrinsic value as time value or even “hope” value. You need a large upward move in the stock price to be profitable with out of the money options. For options currently in the money, they have two components for pricing - intrinsic and extrinsic. Take a look at the July 170 option above as an example, where the ask price is showing $7.90, with apple trading at $174.25. For in the money options, the intrinsic value is the difference between the current stock price and strike price, and the extrinsic value is that which is left over (time or hope value). Using the same example, the intrinsic value is $4.25 and the extrinsic (time, hope) value is $3.65.
  • The extrinsic value for in the money options is the minimum upward stock price increase you will need at expiration just to break even.
  • Time decay - Option pricing is complicated and will not be covered in this article, but one thing to note is that option prices and values decay quickly, especially in the last 15 days before expiration, for which the above example applies.

Case study: BUY 1 contract of the July 175 Apple option for $495. (NOT A RECOMMENDATION!!!). As previously mentioned, option pricing is complicated, but only prior to expiration. At the end of the trading day on expirations day (July 18th in this example), options pricing is very simple. This is because time value no longer matters because there is no more time left. The only thing that matters is the stock price as compared to the strike price. A few possible outcomes for apple closing stock price on July 18th, as well as the profit/loss results are shown below for:

  • Apple closes July 18th at less then $175 - The July 175 option expires worthless and 100% of the $495 invested vanishes into the wind.
  • Apple closes July 18th at $177 - The July 175 option is worth $2, for a loss of $2.95. But since options always deal with 100 share lots, the actual loss is $295. This is a negative return of 60% on invested capital ($495).
  • Apple closes July 18th at $189 - The July 175 option is worth $9, for a gain of $4.05. ($405 for the contract) This is a positive return of 82% on invested capital ($495).
  • Apple closes July 18th at $194 - The July 175 option is worth $19, for a gain of $14.05. ($1405 for the contract) This is a positive return of 284% on invested capital ($495).

Remember, the above example is for illustrative purposes only, and NOT A RECOMMENDATION. In fact, beginning options traders generally stay away from such short term options because they are very volatile and very risky. However, the example above - with an opportunity for either going broke or capturing multi bagger returns -should at least explain what all the fuss is about with options. It is also worth noting that the above example is just one high risk case of using options. Despite their risky image, stock options can also be used in very conservative fashions to protect your portfolio, or even enhance the returns in lower risk manners. Be sure to check out the geldpress bookstore for great recommendations on further reading.

I also recommend:
McMillan on Options, Second Edition (Wiley Trading)
McMillan on Options, Second Edition (Wiley Trading) by Lawrence G. McMillan