Understanding Stock Options

You might have heard about people trading Calls and Puts, but what are they really? This post will go into some detail about stock options as an investment.

What is a Stock Option?

A stock option is a contract that entitles the buyer to buy or sell a stock at an agreed price and date per the contract bought. Stock options come in two flavors, Calls and Puts, which each have their own advantages, as we will see later in the post. There are five components that comprise a stock option that differentiate this investment vehicle from it's parent stock:

Strike Price: the strike price is the price at which the underlying stock needs to go up to or below to exercise.
Expiration: the expiration is a specified date on the contract in which the buyer needs to exercise the option or sell, otherwise the contract expires worthless.
Contract/Stock Ratio: one contract represent 100 shares of the underlying stock.
Type of Contract: Call or Put
The Ability to Exercise: exercising a contract happens differently for Calls and Puts. For Calls, this happens when the Strike Price < Stock Price. For Puts, this happens when the Strike Price > Stock Price. Depending on the contract, the buyer of the contract is entitled to buy or sell 100 shares of the underlying stock at the strike price associated with the contract.

Great, now that we have some background to the sort of terms associated with stock options, let's use some example to see them in action. Please keep in mind that these numbers are fictional and are being used to illustrate the concepts and mechanics of options.

Examples

Scene A - Feb 8 2021 - Stock A Market Price (ticker symbol A): $45

Bob buys three calls expiring on Feb 26 2021, with each contract costing $1.12 at a strike price of $47.50. The contract Bob sees on his brokerage account upon buying is: A $47.50 C 2/26/21. You can see from the condensed format we have the strike price ($47.50), the expiration (2/26/21), the type of contract (Call because of the abbreviated C), but what about the contract/stock ratio and the ability to exercise? How much did Bob actually pay to complete this order? From the ratio, we take the price of each contract and multiply it by the number of bought contracts and multiply again by 100. More simply put:

Premium = # of Contracts * Market Price per Contract * 100

Bob would have paid: 1.12 * 3 * 100 = $336 to enter this position. This brings Bobs initial investment to $336. Ok, so now Bob has contracts for stock A, what happens next? Let us move to the future to three different scenarios so we can illustrate the ""options"" Bob has, as the stock moves.

Scene A Scenario A - Feb 22 2021

Stock A Market Price (ticker symbol A): $49
Bob bought 3 contracts at $1.12 each: A $47.50 C 2/26/21
Current Market Price of A $47.50 C 2/26/21: $2.13

Stock A is now at $49 which is greater than the strike price of the contracts bought back on Feb 8. We see that the current market price of his contracts are now $2.13 and with his three contracts he is now holding a value of $2.13 * 3 * 100 = $639. Bob now has an unrealized gain of $639 - $336 = $303. Wow! But Bob is also able to exercise his Call option, meaning he can buy 100 shares of stock A at $47.50 even though the stock is trading at $49. Let's explore his options:

He can sell all of his contracts back on the market to make a profit of $303
He can exercise all of his contracts to buy 300 stocks of company A
He can hold his contracts in hopes stock A continues to rise
He can do any combination of the three!

But why did the contract price go up? The ability to exercise is a very good thing for options traders. It entitles you to open a potential large long term position by buying the stock at the price promised and contract buy time. This in part drives the value of the contract price up which is why we see the value go up. It also makes sense that when the underlying stock price goes up the derived option price also goes up.

Scene A Scenario B - Feb 22 2021

Stock A Market Price (ticker symbol A): $42.50
Bob bought 3 contracts at $1.12 each: A $47.50 C 2/26/21
Current Market Price of A $47.50 C 2/26/21: $0.40

Stock A is now at $42.50 which is greater than the strike price of the contracts bought back on Feb 8. We see that the current market price of his contracts are now $0.4 and with his three contracts he is now holding a value of $0.40 * 3 * 100 = $120. Bob now has an unrealized loss of $336 - $120 = $216. Bob has lost money, so what can he do?

He can sell his contracts back on the market and take a loss before anymore damage has been done.
He can hold onto his contracts in hopes the stock will move up before the expiration which will drive the price up eliminating his losses.

It's always better to take a loss and get some of your money back. If you hold to long and the expiration rapidly comes into view, you lose the time value of your contracts. Meaning, you lose any hope that the stock price reaches or exceeds the strike price because there is no time left on the contract.

Scene A Scenario C - Feb 25 2021

Stock A Market Price (ticker symbol A): $42.50
Bob bought 3 contracts at $1.12 each: A $46.90 C 2/26/21
Current Market Price of A $47.50 C 2/26/21: $0.13

Stock A is now at $46.90 on Feb 25 (1 day away from expiration) which is less than the strike price of the contracts bought back on Feb 8. We see that the current market price of his contracts are now $0.13 and with his three contracts he is now holding a value of $0.13 * 3 * 100 = $39. Bob now has an unrealized loss of $336 - $39 = $297. Bob has lost a lot of his initial investment, so what can he do?

With only one day left, he can either hold in hopes the stock jumps to get a rise in contract price and then sell. Or Bob can sell now and take a loss.

Wrapping Up

These examples can be extended to the Put case and in fact, I invite you to map that out yourself to test your knowledge. As I'm not a financial advisor I will not be giving any advice on how to trade options, but it is good to know about them if you plan to explore them in the future. They can be a powerful tool in your investment tool belt. I hope you have enjoyed this post!