The Fool FAQ

Options

The Fool FAQ

I'm thoroughly confused by options, right down to the arcane terminology. Just what are options and what do these terms like call, put, strike price and expiration date mean?

Here are some definitions you should read before proceeding to why Fools harbor such distaste for options.

Call Option - A Call is an option contract that grants the buyer the right, but not the obligation, to buy the optioned shares of a company at a set price price (the "strike price"), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires worthless. You buy a call if you think the share price of the underlying security will rise or sell a call if you think it will fall. Selling an option is also referred to as ''writing'' an option. The option seller is called the writer.

Contract - An option contract represents 100 shares of the underlying stock.

Expiration date - The expiration date is the date the option expires. Functionally, expiration dates are always the third Friday of the month.

In-the-money - A call option is in-the-money if the share price of the stock underlying the option is ABOVE the strike price. A put option is in-the-money if the share price of the stock underlying the option is BELOW the strike price. (See the discussion of the strike price below for an example).

Intrinsic value - The intrinsic value is the in-money portion of an option's premium. A call option has intrinsic value if the share price of the underlying security is ABOVE the option's strike price. A put option has intrinsic value if the share price is BELOW the strike price. Look under the definition of the strike price. The example given there of an IBM call option would have intrinsic value whenever the IBM share price is above $110 (the option's strike price).

Premium - The premium is the total cost of an option. It's basically the sum of the option's intrinsic and time value. Note, however, that part of the option's premium is a function of how volatile the option is. For instance, wild trading of options in the case of a company takeover can inflate the option's premium.

Put - A put option is a contract that gives the buyer the right, but not the obligation, to sell the stock underlying the contract at a predetermined price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. You buy a put if you think the share price of the underlying stock will fall, or sell one if you think it will rise. Note, you don't have to own the stock to buy a put. You can buy a put, wait for the price to fall below the strike price, THEN buy the stock and immediately resell it for the higher strike price. The person who sold the put gets stuck with buying the stock at the higher price.

Strike price - Every option has a strike price, which is the price of the underlying stock at which the call option owner has the right to buy the stock, and the put option owner has the right to sell the stock. Let's look at an example. Say you buy one call option contract for IBM at a strike price of $110. Subsequently, Apple Computer buys them out and the share price soars to $140. Your call option gives you the right to buy 100 shares of IBM at $110. Alternatively, since the value of the option has increased, you can simply sell the option for a higher premium than you paid for it.

Time value- The time value is the portion of the option's value that exceeds the intrinsic (in-the-money) value. Let's consider the IBM option mentioned above. What if the share price of IBM falls to $105? In that case, the call option has no intrinsic value since the share price is BELOW the strike price of $110. Whatever the premium of the option is, it is all time value. Whenever the share price of the stock underlying a call is BELOW the strike price, or the price of the stock underlying a put is ABOVE the strike price, the option has only time value. The closer you get to the expiration date, the lower that time value will be.

Time and again, I've seen Fools speak disparagingly of options and all they represent. Are options really that bad? I mean, a lot of folks trade them. They can't be as bad as Fools make out, can they?

We don't hate them, we just don't like them very much. It's nothing personal. We've just seen too many people lose money with them. And too many people are trying to promote them as a road to riches. The only riches generated are in the sales of books explaining how to play the options game.

Basically, options offer the potential for big percentage gains AND 100+% losses on your money (you can lose the total premium plus the commission). They can be seductively appealing because they present the possibility to make "the big score." Unfortunately, the reality is that a whopping 80% of options traders lose their money. And, while technically not considered "gambling," the everyday Fool doesn't stand a chance. Here's why. . .

The most daunting reason not to play with these beastly creatures is the simple statistic---80% of all players lose. Period. No arguments. No contests. Now, there is always one enterprising young Fool in every crowd who intends to be part of the special "20%" who actually make any money. What hurdles must he or she overcome? In order to hit the jackpot at the casino, the Wise man must pull 7-7-7, right? Well, making money in options is like those three magic numbers. For ease of discussion, we'll call each "7" a different name. These three factors are "time," "direction," and "magnitude" (reminds you of high school physics, no?).

Time---Options are "time-wasting" assets. Think of the hourglass with the sands of time sliding away. Well, part of the price that you pay when you buy an option is for "time." And as each day passes, you lose more and more "time" premium. The option goes down in value as time passes. So, you are in a constant game of "beat the clock" with these options. Strike one.

Direction---In order to make money with an option, you also have to be correct about the direction of the stock or index. This isn't always easy, and if you make a mistake, chances are that you'll quickly lose most of your money. If you pick "up" and it goes "down," kiss your money goodbye. Strike two.

Magnitude---assuming you are correct about the direction AND you "beat the clock," you ALSO must be able to predict the minimum amount that a stock will move. Here's an example: You buy a 3 month call option for Joe's Fried Cormeal Nuggets (HUSH) at 20. HUSH is currently selling for $21 and you just know that puppy is going up. The option costs you $450. Remember each option contract is for 100 shares. The intrinsic value is $1 per share and the time value is $3.50 per share. As it turns out, you are right about the price, it does go up, and you are right about the time--the week before it expires it goes up to $24 1/4. Great call. How much do you make? Well, you don't. You lose $25 plus commissions. When the option expires, there is no time value left, so you can sell you option for it's intrinsic value which is $4 1/4 per share. Strike three, you're out. . . of money!

The only way to be a member of the "20% club" is to predict correctly the direction of the stock, the time frame it's going to move in and the minimum magnitude of the move. Unless you have a crystal ball or a direct link into the psychic hotline, chances are you won't beat the odds.

Also, here is another negative aspect of options. Have you ever looked at the bid/ask spread of options? No? Let's say the bid is $6 and the ask $6 3/8. So you can buy the option at $6 3/8 but could only turn around and sell it for $6. That's an instant loss of about $.375, and with options only sold in lots of 100, it's at least a loss of $37.50. And this spread is not so bad as option spreads go. Many spreads correspond to instant 20% or higher losses. That's right off the bat, folks. As soon as you buy, you've lost 20% or more of your money! Pretty pathetic, isn't it?

Hmm, I begin to see the light. But aren't options good for hedging, if not speculation? For instance, what's wrong with buying some puts to protect your gains if you're worried about a stock's staying power or a massive market correction?

Well, there are a few reasons not to hedge your positions in this way. Chief among these is that by doing so, you're betting against yourself. How so? Simple. If you're a true Fool, you're holding the stock in question because you expect it to appreciate in value over time. You're not into watching short-term fluctuations in the share price, being confident that your Foolish research has uncovered an undervalued gem. You're going to let that stock alone so that it will achieve a fairer value and profit you thereby. If you are NOT confident the stock will so appreciate, and regain any value it might lose upon market upheavals, you have no business holding it. Don't buy a put to protect your investment; simply sell it to do so and put your money elsewhere.

Second, by buying a put to protect profits, you're essentially betting on the direction the market will take within the finite lifetime of the option. This is not at all Foolish. Predicting such things is better left to the Wise who reside upon The Street. No one knows which direction the market will take. Why waste your time and money trying to predict this? If you're worried, better to spend your time re-examining the reasons you bought the stock in the first place. If those reasons are still valid, relax. If not, sell it fast and find a stock that DOES meet your Foolish criteria.

Okay, I know it's not Foolish to use options. But could you at least explain to me how they work? Pretty please?

Well, since you asked so nicely ...

For example, let's say that on May 1, July 80 Calls at 1/2 (that's $0.50 per share) are available on Tubulator ElectroMagnetics, Inc. (HEX:TUBE), whose stock is presently priced at $75. That means that it will cost you $50 to purchase one Call option on TUBE ($0.50 * 100 shares). You decide to buy 10 Calls at $500. You think TUBE stock is going to surge between now and the 3rd Friday of July.

If TUBE hits the strike before the expirations date, you can exercise your option and buy 1000 shares from the seller of the option at $80 a share. Of course you could buy them on the market at $80, so there's no advantage to having bought the Calls. The price of TUBE is going to have to surpass the strike price to make this deal worthwhile.

Then there's the matter of that $500 you paid for the Calls. The price of TUBE is going to have to reach 80 1/2 for you just to break even--actually a tad higher to cover the cost of the commission you had to pay to get the Calls. Oh, we forgot to mention commissions before? How careless of us! ;-)

Yes, TUBE has been doing well recently, and we assume it's going up. After all, their new interior-reflective, oscillating magnetron is ready for shipment. But just how sure are you that investors are going to be impressed enough to run the price up $6-7 before July 21? Oh, you say it's a Can't-Miss-Pick in the Kabutt Kalls Newsletter. Well then, why bother with a Foolish opinion -- you can't miss! ;-)

But let's assume that it does go up, all the way to 82, for instance, before the expiration date. Then you would definitely make some profit. You can buy those 1000 shares at 80 and immediately turn around and sell them for 82, which is $2000. Minus the $500 that you paid for the Calls, minus the original commission on the Calls, minus the commission on the buy, minus the commission on the sale... Somewhere between $1400 and $1450.

If you had bought 1000 TUBE at $75, they would be worth $82,000 today and you'd be looking at a $6,000 profit (minus only two trading commissions, if you were to sell them now).

So why would anyone be interested in buying Calls? Leverage! In this example buying the Calls would only cost you $500 to make $1400 (almost tripling your money). Buying the stock would cost you $75,000 to make $6,000, only an 8% return. So which would you rather have, $1400+ from the deal or 1000 shares of TUBE which has been moving up rather nicely of late? Some people would go for the options; we Fools would rather have the stock.

Bear in mind, that the above situation is one of the 20% successful call option buys. 80% of the time that option would have expired worthless.

But isn't it pretty safe if you are on the other side? Selling the option instead of buying it?

Well, suppose you had sold the call above? If you write (sell) July $80 calls at $0.50 on 1000 shares of TUBE, you're betting that the price won't go to (or above) $80 before the 3rd Friday in July. You'll get $500 for your sale; but if the price does goes to $82 and the buyer exercises his option, you will have to supply him with the 1000 shares.

If you sold COVERED CALLS, it means you owned 1000 shares of TUBE and will now have to sell them to the buyer for $80,000. You made $500 on the option, but you lost the appreciation from $80 to $82 for a net loss of $1500 on this particular deal.

If you sold NAKED CALLS, it means you have buy 1000 shares of TUBE (that's $82,000 out of pocket for a few days) and sell them to the buyer for $80,000. The premium cushions you somewhat, but your net loss is still $1,500. (Not to mention the cost of antacid as July 21 approaches! :)

Since 80% of options expire worthless, some people write options as a source of income. This is not investing, however; it's speculating on the price movement of a stock. It may or may not be foolish, but it certainly isn't Foolish. :-)

What's going on here? Is Wall Street populated by a bunch of superstitious folks? Just what is Triple Witching and why should anyone care?

Triple witching refers to the market machinations brought on by the simultaneous expiration of stock index futures, stock index options, and stock options. This happens four times a year, on the third Fridays of March, June, September, and December. To be precise, the phrase is Triple Witching Hour, and refers to the last hour of trading on these Fridays. The expiration of these vehicles can cause high volatility in stock prices as traders play madly with the expiring vehicles and the underlying securities.

The weird sisters, hand in hand,
Posters of the sea and land,
Thus do go about, about:
Thrice to thine, and thrice to mine,
And thrice again, to make up nine.
Peace! The charm's wound up.

Macbeth, I,iii,32

Fools don't care much about triple witching, unless it's the Shakespearean variety. That's because no true Fool would focus so closely on an investment to be concerned with the price performance on any one day. Forget about triple witching, and take a long weekend!

Now you know why we don't have a lot of information on options on our site. But, if our Foolish explanation doesn't satisfy your thirst for knowledge, you can find a great deal of very useful information on options at the Chicago Board Options Exchange website: http://www.cboe.com/LearnCenter. Please, pay attention when they explain the risks.