All About Stock Options

My goal is to give you a basic understanding of what stock options are all about without hopelessly confusing you with unnecessary details. I have read dozens of books on stock options, and even my eyes start glazing over shortly into most of them. Let’s see how simple we can make it.

Basic Call Option Definition

Buying a call option gives you the right (but not the obligation) to purchase 100 shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the third Friday of a specific month (called the expiration date).

People buy calls because they hope the stock will go up, and they will make a profit, either by selling the calls at a higher price, or by exercising their option (i.e., buy the shares at the strike price at a point when the market price is higher).

Basic Put Option Definition

Buying a put option gives you the right (but not the obligation) to sell 100 shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the third Friday of a specific month (called the expiration date).

People buy puts, because they hope the stock will go down, and they will make a profit, either by selling the puts at a higher price, or by exercising their option (i.e., forcing the seller of the put to buy the stock at the strike price at a time when the market price is lower).

Some Useful Details

Both put and call options are quoted in dollar terms (e.g. $3.50), but they actually cost 100 times the quoted amount (e.g., $350.00), plus an average of $1.50 commission (charged by my discount broker – commissions charged by other brokers are considerably higher).

Call options are a way of leveraging your money. You are able to participate in any upward moves of a stock without having to put up all the money to buy the stock. However, if the stock does not go up in price, the option buyer may lose 100% of his/her investment. For this reason, options are considered to be risky investments.

On the other hand, options can be used to considerably reduce risk. Most of the time, this involves selling rather than buying the options. Terry’s Tips describes several ways to reduce financial risk by selling options.

Since most stock markets go up over time, and most people invest in stock because they hope prices will rise, there is more interest and activity in call options than there is in put options. From this point on, if I use the term “option” without qualifying whether it is a put or a call option, I am referring to a call option.

Real World Example

Here are some call option prices for a hypothetical XYZ company on February 1, 2010:
Price of stock: $45.00

Expiration Date
Strike Price	Feb ’10	Mar ’10	Jan ’12	Terminology of Option
(price of call option)
40	$5.50	$7.00	$18.50	“in-the-money” (strike price is less than stock price)
45	$2.00	$4.00	$16.00	“at-the-money” (strike price is equal to stock price)
50	$0.50	$1.00	$14.00	“out-of-the-money” (strike price is greater than stock price)

The premium is the price a call option buyer pays for the right to be able to buy 100 shares of a stock without actually having to shell out the money the stock would cost. The greater the time period of the option, the greater the premium.

The premium (same as the price) of an in-the-money call is composed of the intrinsic value and the time premium. (I understand that this is confusing. For in-the-money options, the option price, or premium, has a component part that is called the time premium). The intrinsic value is the difference between the stock price and the strike price. Any additional value in the option price is called the time premium. In the above example, the Mar ’10 40 call is selling at $7. The intrinsic value is $5, and the time premium is $2.

For at-the-money and out-of-the-money calls, the entire option price is time premium. The greatest time premiums are found in at-the-money strike prices.

Options that have more than 6 months until the expiration date are called LEAPS. In the above example, the Jan ’12 calls are LEAPS.

If the price of the stock remains the same, the value of both puts and calls decreases over time (as expiration is approached). The amount that the option falls in value is called the decay. At expiration, all at-the-money and out-of-the-money calls have a zero value.

The rate of decay is greater as the option approaches expiration. In the above example, the average decay for the Jan ’12 45 LEAP would be $.70 per month ($16.00/23 months). On the other hand, the Feb ’10 45 call option will decay by $2.00 (assuming the stock stays the same) in only three weeks. The difference in decay rates of various option series is the crux of many of the option strategies presented at Terry’s Tips.

A spread occurs when an investor buys one option series for a stock, and sells another option series for that same stock. If you own a call option, you can sell another option in the same stock as long as the strike price is equal to or greater than the option you own, and the expiration date is equal to or less than the option you own.

A typical spread in the above example would be to buy the Mar ’10 40 call for $7 and sell the Mar ’10 45 call for $4. This spread would cost $3 plus commissions. If the stock is at $45 or any higher when the options expire on the 3rd Friday in March, the spread would be worth exactly $5 (giving the spread owner a 60% gain for the period even if the stock stays the same – less commissions, of course).

Spreads are a way of reducing, but not eliminating the risks involved in buying options. While spreads may limit risk somewhat, they also limit the possible gains that an investor might make if the spread had not been put on.

This is an extremely brief overview of call options. I hope you are not totally confused. If you re-read this section, you should understand enough to grasp the essence of the 4 strategies discussed in Terry’s Tips.

Stock Option Symbols

In 2010, option symbols were changed so that they now clearly show the important fearure of the option – the underlying stock that is involved, the strike price, whether it is a put or call, and the actual date when the option expires. For example, the symbol SPY120121C135 means the underlying stock is SPY (the tracking stock for the S&P 500), 12 is the year (2012), 0121 is the third Friday in January when this option expires, C stands for Call, and 135 is the strike price.

Stock LEAPS are one of the greatest secrets in the investment world. Hardly anyone knows much about them. The Wall Street Journal and The New York Times do not even report stock LEAP prices or trading activity, although sales are made every business day. Once a week, Barron’s almost begrudgingly includes a single column where they report trading activity for a few strike prices for about 50 companies. Yet stock LEAPS are available for over 400 companies and at a great variety of strike prices.

LEAPS, Simply Defined

Stock LEAPS are long-term stock options. The term is an acronym for Long-term Equity AnticiPation Securities. They can be either a put or a call. LEAPS typically become available for trading in July, and at first, they have a 2.5-year lifespan.

As time passes, and there are only six months or so remaining on the LEAP term, the option is no longer called a LEAP, but merely an option. To make the distinction clear, the symbol of the LEAP is changed so that the first three letters are the same as the company’s other short-term options.

LEAPS Are Tax-Friendly

All LEAPS expire on the third Friday of January. This is a neat feature because if you sell a LEAP when it expires, and you have a profit, your tax is not due for another 15 months. You can avoid the tax altogether by exercising your option. For example, for a call option, you purchase the stock at the strike price of the option you own.

Owning Call LEAPS Is Much Like Owning Stock

Call LEAPS give you all the rights of stock ownership except voting on company issues and collecting dividends. Most importantly, they are a means to leverage your stock position without the hassles and interest expense of buying on margin. You will never get a margin call on your LEAP if the stock should fall precipitously. You can never lose more than the cost of the LEAP – even if the stock falls by a greater amount.

Of course, LEAPS are priced to reflect the inputted interest that you avoid, and the lower risk due to a limited downside possibility. Just like in everything else, there’s no free lunch.

All Options Decay, But All Decay is Not Equal

All LEAPS, like any option, go down in value over time (assuming the stock price remains unchanged). Since there are fewer months remaining until the expiration date, the option is worth less. The amount that it declines each month is called the decay.

An interesting feature of the monthly decay is that it is much smaller for a LEAP than it is for a short-term option. In fact, in the last month of an option’s existence, the decay is usually three times (or more) the monthly decay of a LEAP (at the same strike price). An at-the-money or out-of-the-money option will plunge to zero value in the expiration month, while the LEAP will hardly budge.

This phenomenon is the basis for many of the trading strategies offered at Terry’s Tips. Quite often, we own the slower-decaying LEAP, and sell the faster-decaying short-term option to someone else. While we lose money on our LEAP (assuming no change in the stock price), the guy who bought the short-term option loses much more. So we come out ahead. It may seem a little confusing at first, but it really is quite simple.

Buy LEAPS To Hold, Not To Trade

One unfortunate aspect of LEAPS is due to the fact that not many people know about them, or trade them. Consequently, trading volume is much lower than for short-term options. This means that most of the time, there is a big gap between the bid and asked price. (This is not true for QQQQ LEAPS, and is one of the reasons I particularly like to trade in the Nasdaq 100 tracing equity.)

The person on the other end of your trade is usually a professional market maker rather than an ordinary investor buying or selling the LEAP. These professionals are entitled to make a profit for their service of providing a liquid market for inactively traded financial instruments such as LEAPS. And they do. They manage to sell at the asked price most of the time, and to buy at the bid price. Of course, you are not getting the great prices the market maker enjoys.

So when you buy a LEAP, plan on holding it for a long time, probably until expiration. While you can always sell your LEAP at any time, it is expensive because of the big gap between the bid and asked price.