An option is a securities contract that allows the holder to buy or sell a fixed amount of shares of stock (or indexes and commodities) at a specified price within a limited time period. If the option is not exercised during the specified period, the option expires. Most options usually expire within a year; however, some may not expire for as long as three years. A person selling an option is referred to as a writer, and a person buying an option is referred to as a buyer. The two option types discussed in this paper are call options and put options, and it explains the effect they have on writers and buyers.
What Are Call Options?
A call option gives an investor the right to buy 100 shares of a particular security (stock, bond, commodity or other instrument), at a fixed price, before a specified date (usually three, six or nine months). A call is profitable, at expiration, when the current market price of the stock is higher than the strike price, plus the premium.
For example, a call option on 100 shares of XYZ stock may grant its buyer the right to buy those shares at $100 a piece anytime in the next three months. To buy that option, the buyer may have to pay a premium of $2 per share, or $200. At the time of the option contract, if XYZ is selling for $95 a share, the options buyer will profit if XYZ’s stock price rises. If XYZ moves up to $120 a share in two months, the option buyer can exercise his or her option to buy 100 shares of the stock at $100. The option buyer then sell the shares for $120 each, keeping the difference as a profit, minus the $2 premium per share. On the other hand, if XYZ drops below $95 and stays there for three months (at the end of that time) the call option will expire. Then the call buyer will receive no return on the $2 per share investment premium of $200**.
What Are Put Options?
A put option is the opposite of a call option. It gives an investor the right to sell shares of a stock, at a fixed price, within a specified time period. Buyers of a put option expect the price of the underlying stock to fall. A put is profitable at expiration, when the current market price of the stock is lower than the strike price, less the premium.
For example, someone who thinks XYZ’s stock price might fall will buy a three month XYZ put for 100 shares at $100 a piece, and pay a premium of $2. If XYZ falls to $80 a share, the put buyer can then exercise his right to sell 100 XYZ shares at $100. The buyer will first purchase 100 shares at $80 each then sell them to the put options seller (writer) at $100 each; making a profit of $18 a share (the $20 a share profit minus the $2 premium)**.
Who Profits From Options?
Option buyers anticipate a change in the option’s underlying stock price at some point prior to expiration that will make the option worthwhile to exercise. On the other hand, a writer (seller) does not anticipate a price change will occur; therefore, allowing the option to expire worthless. In this scenario, the writer will retain the entire amount of the option premium that was received for writing the option. Option writing can be extremely risky and leaves the writer in a position of unlimited risk.
A buyer of a call option is generally viewed as “bullish.” They will pay the call option writer a fee, or a premium. If the option is not exercised before it expires, the premium paid is lost. Buyers of call options believe that the price of the underlying security will rise before the option expires. If the buyer exercises the option, the shares are purchased from the writer at the option’s strike price. The amount due to the writer is the strike price multiplied by the number of shares. A writer of a call option believes the underlying security will not substantially increase, thus, not making it worthwhile for the buyer to exercise. For the writer, the break-even price is the option strike price, plus the net premium received after transaction costs.
A buyer of a put option is generally viewed as “bearish.” Buyers of put options expect the price of the underlying security to fall. If the put buyer exercises the option, the shares are sold to the writer at the option’s strike price. A writer of a put option believes the underlying security will not substantially decrease, thus, not making worthwhile for the buyer to exercise. For the writer, the breakeven price is the option strike price, minus the premium received after transaction costs.
In actuality, most call and put options are rarely exercised. Instead, investors usually buy and sell options before the expiration date. Buyers may attempt to profit on the option by selling it before its expiration date by trading on the rise and fall of premium prices. Writers may also attempt to profit by buying back the option sold at a lower price.
What Does Henssler Financial Recommend for Options?
Henssler Financial usually does not recommend option trading, except in very unique situations in order to protect the value of the holdings. The options market has become very sophisticated and complex. Anyone who does not fully understand the extent of the risks involved, and who cannot afford the possibility of unlimited losses, should not trade in options. Before investing into options, it is always important to address any questions or concerns with a financial adviser. For more information regarding this topic, please contact Henssler Financial at 770-429-9166, or [email protected].
** Examples taken from Barron’s Finance & Investment Handbook, Fourth Edition, John Downes and Jordan Elliot Goodman, 1995.