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.
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.