Difference in Stocks and Stock Options

Usually, in high-end restaurants, you need to make a reservation before you can secure yourself a seat and try their good food. Sometimes, these reservations require a fee before the restaurant grants you dibs. It would be a shame if you don’t show up, but you are not at all required. Therefore, you have a right, but not an obligation to dine at that restaurant at the specified date and time of your reservation.

Stock options are like reservations in the sense that it grants you an option to purchase stocks. Although, it should be noted that stock options are not limited to only buying stocks ? we’ll go deeper into this in a while. In this analogy, stocks, on the other hand, represent goods and services offered by the restaurant.

Alright, so you now that you have a general picture of the difference between stocks and stock options. Let’s now have a deep dive on what stock and stock options are and how they are entirely unique from each other.

What are stocks?

Stocks, a term used interchangeably with ?shares?, is an intangible item representing ownership of a portion of a company’s assets and profits. When corporations need to expand and raise capital, they offer their stocks to the investing public. Interested parties give out a consideration, usually in the form of money, in exchange for a company’s stocks. Companies and individuals who have acquired these stocks are called stockholders or shareholders.

So what’s in it for the investors? In exchange for their money or other forms of consideration, they are given a parcel of ownership in the company. That means that they are entitled to participate in the company’s earnings and a claim on the company’s assets. Of course, in most cases, there are going to be a lot of stockholders in a company, which means there are also going to be a lot of owners. How much of an ownership, then, would each stockholder have?

Easy. Ownership would be tantamount to the number of stocks held in proportion to the total number of shares issued by the corporation. For example, a stockholder owns 200 shares in Company X and the total number of shares issued by that company is 1,000. In this case, the stockholder essentially owns 20% (200/1,000) of the corporation.

Stockholders may earn in two ways through stocks:

  • They can either choose to hold their stocks and earn through receiving dividends from the corporation. Dividends are a distribution of the company’s earnings to its stockholders as decided upon by the board of directors.
  • Another way for stockholders to earn is through stock trading or selling their shares to other interested investors for a profit in the stock market. Stock trading focuses more on buying and selling stocks treating stocks as inventories rather than long-term investments.

What are stock options?

A stock option is a contract that gives the right to the holder to buy or sell shares of a specific company, at a specified price, and within a specified period or on a certain date. Still sounds a little confusing? Like restaurant reservations, the holder of a stock option has the right, but not an obligation to buy or sell stocks just like the holder of the reservation is not obliged to show up at the restaurant but has the right to. However, also like restaurant reservations, the holder of stock options has to exercise this right during the specified time. Otherwise, it expires and basically becomes worthless just like a reservation lapses after the agreed date and time.

The concept of options is found in everyday life situations. For example, you find a classic Corvette you’ve been dying to have. Unfortunately, you likely do not have enough cash to enable you to buy that Corvette right now but it’s definitely in your pipeline. Demand for that car is off the charts and it is likely that supply will run low soon. So you talk to the dealership and they’ve agreed to grant you an option to purchase the Corvette within three months for $85,000. However, this option does not come for free! The owner of the dealership tells you: ?you have to pay $1,000 for dibs?. If you buy the car within three months as agreed, then you’ve already exercised your right to purchase. Otherwise, you don’t get the car for 85 grand and you’ve passed up a one grand worth of opportunity.

Terms of the Trade

Now, before we go into the detailed examples and illustrations for stock options, let’s familiarize ourselves first with the terminologies that one would likely encounter when dealing with stock options.

  • Call Options ? gives the holder the right to buy shares at a specified price and time frame. Generally, buyers of call options are optimistic about the future performance of the underlying stock and hope that the stock price will increase before the options expire.
  • Put Options ? gives the holder the right to sell shares at a specified price and time frame. Generally, buyers of put options are pessimistic about the future performance of the underlying stock and hope that the stock price will decline before the options expire.
  • Strike Price ? the price at which the stock is agreed to be bought or sold when the option is exercised. Also known as exercise price.
  • Expiration Date ? to state the obvious, this is the date by which the options have to be exercised or else they become worthless.
  • Market Price ? the price at which a stock is currently traded in the stock market.
  • Premium ? the price that the buyer of the options pays to the writer (seller of options) for the right to buy or sell the underlying stocks. Premiums are quoted on a per-share basis. For instance, a quote price of $0.80 means that the buyer of the option pays $0.80 per share, based on how many shares the individual will have the right to buy or sell.
  • Options Contract ? the agreement between the buyer and seller of the options that gives the buyer the right to either purchase or sell the underlying asset at the strike price. Basically, this is the formalization of options. Typically, each stock option contract is written in 100 shares. Which means a holder of one options contract can purchase 100 shares of a specified company should he decide to exercise the option.
  • Break-Even Price ? the point at which the gains will equal the losses. In stock options, it refers to the market price that a stock must reach for option buyers to avoid a loss if the option gets exercised.

Some illustrative examples to help you visualize

Okay, so let’s get into some specific scenarios to help you understand how this stock options thing works. Let’s take Charlie Confectionery Company as the hypothetical corporation in our examples.

Example 1:

Let’s say that on August 1, the market price of Charlie Confectionery Company is $98 and the premium for options costs $4.50 for an October expire with a strike price of $100 call. This means that the expiration date of the call options is the third Friday of October. The total price of one option contract in this case is $450 ($4.50 premium * 100 shares per option contract).

You decide to buy one call option contract.

A strike price of $100 means that the stock price has to rise above $100 before the call option becomes valuable (excluding time value of money, volatility and other factors; we’ll get into that another time). Why? Because if the market price stays at $98 or goes further down, the option to buy at $100 is practically not on the table. Since people could buy the stock of Charlie Confectionery Company for a lower market price.

Another important thing to consider when dealing with stock options is the break-even price. For a call option, the break-even price is equal to the strike price plus the premium per share. In this example, the break-even price is $104.5 ($100 strike price + $4.50 premium). Therefore, the stock price must be able rise higher than $104.50 to avoid losses when the option is exercised.

Let’s jump to the first week of October. The stock price went up to $107 as you hoped. Since the value of the call options also move proportionately along with the underlying stock, the value of your call options also increased to, say, $7.50 per share. At this point, you already have an unrealized profit of $3 per share ($7.50 current options price – $4.50 options premium paid) or a total of $300 ($3 * 100 shares). Great, right?

Now you have two alternatives ? either you can take advantage of this increase in the value of your options by selling them through option trading (see Option Trading 101 section of this article) or ride along for a little bit more if you think the stock price will continue to rise. Let’s say you have decided on the latter.

Come third week of October (before Friday), let’s say the stock price increased further to $110, and the stock option value also increased to $10.30. You may either sell your call options to those who wish to purchase the stocks of Charlie Confectionery Company or exercise the right to buy 100 shares. If you choose the former, your total gain would be $580 [($10.3 – $4.5) * 100 shares]. If the latter, your possible total profit would be $550 (($110 market price – $100 strike price) *100 shares – $450 premium). In general, it rarely makes sense to exercise an ?American? option (as a posed to European, exotic and other options) before it’s expiry date because you’d be better off selling it instead.

On the other hand, in the unfortunate event that the stock price falls to, say, $95, then the call options you hold would be worthless. Your total loss then, in this case, is equal to the premium you have paid originally which is $450.

Example 2: Put Options

So now it’s the other way around. Your analysis shows that it is likely that the market price of Charlie Confectionery Company stock will fall. On August 1, the market price of its stock is $98 and the premium for their stock options is $3 for an October $95 strike price put. This means that the expiration date of the put options is the third Friday of October with the strike price of $95. You decide to purchase one put option contract with a total price of $300 ($3 premium * 100 shares). Now you have the right, but not the obligation, to sell the shares for $95.

In this case, the stock price must fall below $95 to make the put options worth anything by the expiry date. Why? Because why sell the stock for $95 when it can be sold for more than that? The break-even price for put options is equal to the strike price less the premium paid. Therefore, the break-even price here is $92 ($95 strike price – $3 premium). This means that the stock price must fall below $92 by the expiry date to ensure there are zero losses from your end. But again, you can sell your put option before the expiry date.

During the first week of October, the stock price indeed fell to, say, $91. The value of your put options, which is inversely proportional to the underlying stock price, increases to $4.50 per share. Your unrealized gain due to the increase in the value of your put options equals to $1.50 per share or a total of $150 ($1.50 gain * 100 shares). 50% return from your original $300, not bad!

Now, you can either sell these options to the open market or keep your options a bit longer. Let’s say you take the latter approach. Come third week of October, the stock price went down further to $88. While it’s a lucky Chinese number, it’s not good for existing stockholders of this particular company. Some of them would want to sell since the stock is not doing too well.

The value of your put options now increases to, say, $7.50. If you sell these put options, you get a profit of $4.50 per share or a total of $450 (($7.50 – $3) * 100 shares). You could also exercise your right to sell the shares for $95. If you choose to exercise, your total profit will be less; $400 (($95 strike price – $88 current price) * 100 shares – $300 premium).

Now, if things unfortunately did not go your way and the stock price went up to $100 as of the exercise date, exercising your put options would not make sense. Why sell it for $95 when you can sell it for $100? Your total loss in this case would be the premium you have paid which is $300.

Option Trading 101

Now, here’s a million-dollar question ? Who issues the options? We have learned a lot about options thus far but where do these come from? The theoretical answer is that anyone can create and issue stock options. As long as you have the right supply and demand, you and another party can shake on it, deliver on your stipulations and voila! ? you got yourself an option contract. Practically, though, the answer would be exchanges, brokerage firms/intermediaries and the company itself. They have adequate legal resources to make the contracts enforceable and right amount of capital to back up their side of the contract. However, you can only buy and sell what they can offer.

In the examples provided above, you may have noticed that as a holder of the options, you always have the choice to trade these options into the open market or the options market. Like stocks, stock options are also financial instruments. Stocks option is an example of derivatives: They derive their value based on the underlying item, which is ? you’re correct! ? The company’s stock. Therefore, as stock prices change, their value also changes.

Option trading may be done independently in organized exchanges or trading through a brokerage firm. Option trading became popular due to the options’ flexibility and possibility for ?low cost high returns?.

How are stocks and stock options similar?

  • They are both financial instruments and both are tradable.
  • They are both listed securities. Like stocks, listed option orders are executed on the trading floors of organized exchanges where all trading is conducted in an open, competitive auction market.
  • Option investors, like those of stocks, have the ability to follow price movements, trading volume and other information on a real-time basis.

How are stocks and stock options different?

  • Stock options have expiration dates, while stocks do not. You can hold a stock of an active company indefinitely but a stock option expires at some point in the future.
  • Stock options are derivatives, while stock are not. Stock options derive their values based on the underlying stock price and other variables; while stocks do not depend on an underlying item for its valuation.
  • Stock options do not represent ownership in a company but merely a right to buy or sell its stocks. Stocks, on the other hand, entitle the holder to the assets and earnings of a company.

What are Stock Options?

So you want to get into trading options, but don’t know where to start? That’s okay, because learning options is like learning anything else: You just need practice. That’s not to say options trading isn’t hard, because some of the methods can be quite complex. We’ll get into some of that later, but for now, let’s stick to the basics.

The first step to options trading is having experience in either trading or investing. Sounds anticlimactic, I know, but trading options is a tool that should be added to your arsenal of investing or trading strategies; not the starting point. In other words, you wouldn’t learn how to be a professional race car driver without first getting your license.

Let’s go with the assumption that you do have experience in either trading or investing and are simply looking to widen your knowledge of the financial markets.

So what exactly is an option? It’s called an options contract for a reason, and that’s because the buyer and seller are actually entering into an agreement where one party (the buyer) has the right to X amount of shares at X price on X date. The other party (the seller) has the obligation to deliver that predetermined amount of shares at a specific price on a specific date.

One standard options contract is good for 100 shares. The agreed upon price is referred to as the ?strike price? and the date is referred to as the ?expiration date.?

In its most basic form, investors are faced with two options – no pun intended – when trading options: to buy calls or buy puts.

For all intents and purposes, if you believe shares of ABC are going higher, you would buy call options, and if you believe shares of ABC are going lower, you would buy put options.

Seems simple enough, right? If only it were that easy.

Now if you’re starting to feel overwhelmed, that’s okay. Everyone’s a little apprehensive their first time, but as with most things in life, it gets much easier after some experience.

How Do Call Options Work?

Let’s start with an example and go from there. Let’s say we’re really bullish on shares of ABC and we think the stock is going much higher. Currently, ABC is trading at $62 and its February 21st. We want to be long ABC, but don’t want to commit $6,200 in order to buy 100 shares because of other macro-related risks, like a broad market selloff.

Instead, we look at the options chain, which displays all of the options available for ABC, along with strike prices and expirations.

We’ll have to chose a time period, or how long we’ll want to own the option. Some expire in as little as a week, while others expire in a few years, which are referred to as LEAPS (Long-term Equity AnticiPation Securities). For our situation, we just want the option for a few months, so let’s pick the April monthly expiration*. That will give us roughly two months for our play to pan out.

*Standard monthly options expire following the third Friday of each month.

Finally, we’ll have to choose a strike price, which is the level we’ll have the right to purchase the stock come expiration day. With the stock at $62, any call option strike price below that level is considered ?in-the-money? or ITM, and any strike price above that level is considered ?out-of-the-money? or OTM. And as you may have guessed, the strike price nearest the stock price is considered ?at-the-money? or ATM.

Generally speaking, the deeper in-the-money the option is, the more it will cost. That’s because option prices are made up of a few things, time value and intrinsic value being two of them.

Intrinsic value measures how much the option is worth right now, as if it were to expire today. Time value is how much extra premium is priced into the option. Eventually, the time value will drop to zero at or near expiration.

In our example, with ABC trading near $62, we know that the $60 strike call option has an intrinsic value of $2.00 per share, because if it were to expire today, the option is already $2.00 per share in-the-money.

However, if the option still has several months until expiration, it’s likely that the $60 option could trade for around $4.25 – meaning $2.00 of the option is composed of intrinsic value and the rest, or $2.25 in this case, is composed of time value.

Likewise, a stock that’s out-of-the-money trades with no intrinsic value and all time value. For instance, in our example with ABC at $62, the $65 strike call option costs $2.00. Since the call option is out-of-the-money, it would be worthless if expiration were today. So the entire cost of the $2.00 option is all time value.

Options pricing is not an easy science – in fact, it’s quite complex. That’s why so many people struggle to understand these instruments.

So let’s focus exclusively on our example to make sense of it all. Remember, we’re bullish on ABC, which is trading at $62 in late-February. To play an upside move over the next two months, we’re going to purchase one $65 strike call option for $2.00 that expires in April.

Rather than risking $6,200 to buy 100 shares of the stock, we’re risking $200 on the call option instead.

While the $65 strike option may have no intrinsic value at the moment, and the time value will decay over time, it will be a slow process, and the option will still gain in value should shares of ABC rise significantly over the next 6-8 weeks like we believe it will do.

Our break-even on the trade is $67, which is the strike price plus the premium we paid for the call option, ($65 strike price + $2.00 premium = $67 break-even).

Shares of ABC begin climbing and when we finally get to April expiration, the stock is trading at $70 per share. The time value of our option will have dropped to $0, but the intrinsic value is worth $5.00, ($70 current stock price – $65 strike price = $5.00 per share). This also represents our gross profit – but remember to multiply the outcome by 100, for each share in the option contract.

To calculate our net gain, we have to subtract the cost of the option, which was $2.00 ($200), from our gross profit of $5.00 ($500).

$5.00 – $2.00 = $3.00 ($300) net profit.

In this case, we risked $200 and generated a net profit of $300, good for a 150% return.

Do We Want to Exercise?

Come expiration day, investors are forced to choose between two options – again, no pun intended. We’ll either need to sell the call option, realizing our $300 gain, or we’ll need to exercise the option, which will ?call? away the stock from the seller at $65. Assuming we exercise the stock, we’ll pay out $65 for each share in the contract, or $6,500 total.

Remember though, our cost basis will actually be $67 per share, because we paid $2.00 per share for the options contract. You may notice that the $3.00 per share difference in your cost basis when exercising and the stock’s current price of $70 also represents a $300 gain, the same gain we would have by simply selling the option.

To exercise or not to exercise? In my personal experience – and generally in most traders’ experience – exercising is a rare event. You typically wouldn’t exercise your rights to the stock, unless you truly wanted to own the stock at that level.

Because the profit on the day of expiration is the same, most traders opt to book their gains and move on.

This is where right vs. obligation comes into play. As the buyer of the call option, you have the right to exercise the call option. In fact, you can exercise any day that you want prior to expiration day, assuming you’re trading U.S. equity options. This type of exercise is called American style, whereas European style only allows the buyer to exercise their options on expiration day.

While the buyer has the right to exercise whenever they chose, the seller of the option has no choice. Instead, they have the obligation to fulfill their end of the bargain, and provide 100 shares per contract at the predetermined price, should the buyer chose to exercise.

Keep in mind that either the buyer or the seller can close their position at any time prior to expiration as well. If the stock has rallied and the call buyer wants to book their gains early, they can do so by simply selling their call option. If the seller of the call option feels like they’re losing too much, they can cut their losses and close their position as well, (more on selling options later).

Also keep in mind that should your option close in-the-money by $0.01 or more, your option will be automatically exercised if you hold it through expiration.

Just remember: The buyer has the right, the seller has the obligation.

What About Put Options

Put options work the same way call options do – only in the opposite direction. Just like call options give the buyer the right to purchase stock at a certain price, put options allow the buyer the right to sell the stock at a certain price.

Again, let’s take ABC as our example. The stock is trading near $62 in late-February and we’ve grown quite bearish on the company’s prospects over the next few months. Rather than having unlimited risk to the upside by shorting the stock, we instead look to buy put options.

Put options, for the purpose of this discussion, gain in value when the underlying stock declines.

When looking for call options, strike prices below the current stock price are considering ITM, whereas with put options, strike prices above the current stock price are considered ITM. This is because if we were to exercise the put option today, it would give us a short position in the stock above today’s current share price, meaning the option holds intrinsic value.

Now that our hypothesis concludes shares of ABC are headed lower, we’ll need to pick a strike price and an expiration date. For this example, let’s say the April expiration $60 put option is trading for $2.50.

Our break-even on the stock for this trade is $57.50, which is the strike price, along with the premium for the put option. ($60 – $2.50 = $57.50).

A few weeks go by and ABC reports disappointing earnings alongside a pessimistic economic backdrop for the broader economy. Shares tumble lower and come expiration day in April, the stock is trading at $52. What’s our gross profit? What’s our net profit?

Remember, to find the gross profit we simply subtract the stock’s current price, $52 in this case, from the strike price of $60. $60 – $52 = $8.00, ($800).

To find our net profit, we have to subtract our cost of the option from the total gain, so it’s $8.00 – $2.50 = $5.50 ($550). Our tidy profit of $550 represents a 220% return in value, despite the underlying stock falling just 16%.

Just like with the call option, the most we risk by purchasing the put option is our premium, in this case $2.50 ($250). In the event of a stock rally, our put option will expire worthless if the stock closes above $60 on expiration. While losing $250 is never fun, we can always chose to cut our losses after a predetermined decline, say of 50%, so we’ll only lose $125.

Even a full lose of $250 is much better than the potential outcome of a rally when short 100 shares. If ABC were to climb to $70 and we were short 100 shares at $62, our losses would be $800, much more than the $250 we risked on the put option.

The bad thing about buying options is that you can lose 100% of your investment, meaning the option can expire worthless if it doesn’t move in your desired direction. On the flip side though, the amount of capital required for buying one call or put option is usually a fraction of the cost of buying or shorting 100 shares of that same security. Plus, you know your maximum downside right off the bat.

In the next article, we’ll look at how to generate extra income in sideways to slightly down markets, how to get paid to buy a stock at a cheaper price than it’s trading at today, and what the difference is between the ?bid? and the ?ask.?

A Little Recap

Call Option – When bought, buyer agrees to purchase 100 shares of stock at a predetermined price.

Put Option – When bought, buyer agrees to sell 100 shares of stock at a predetermined price.

Strike price – The exercise price of the stock option.

Expiration Date – The day in which the option expires; available in weekly, monthly, quarterly and LEAPS expirations. Monthly options expire following the third Friday of each month.

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