WHAT IS STOCK OPTIONS: MEANING, TYPES, CONTRACTS AND OPTION TRADING STRATEGIES

What are stock options?

Stock options give investors the right to either buy or sell a stock at an agreed price and date. Stock options serve as a right and not an obligation. Just like other classes of assets with brokerage investment accounts, options can be acquired in the same manner. Options can be viewed as powerful tools because they have the ability to enhance an investor's portfolio by increasing income, providing additional protection and leverage as well. Based on the situation that may be on the ground, there is always a suitable option that aligns with an investor's goal at that point in time. 

Options belong to a larger security group called derivatives and the prices of derivatives depend on the price of another item. For instance, petrol is a derivative of crude oil, thus, a stock option is a derivative of a stock. In constructed terms, options are derivatives of financial securities and their value depends on the price of other assets. Examples of options include calls, puts, futures, forwards, swaps, mortgage-backed securities and many more.

Types of options

There are basically two types of options, these are, calls and puts. Each option strategy makes use of one or both of these types of options as its building blocks.

Call Options

Call options are derivatives that give the buyer the right (not the obligation) to buy a security from the owner at a specific price during a specified period of time. Buying calls take place when an investor is bullish about the direction of the stock market.

Imagine this scenario of a call option. A potential real estate investor sees a new home been developed and picks interest in it. This investor will want the right to purchase the home after some time (let's say two years) after some designer fittings have been made. This potential investor can buy a call option from the developer of the home at $300,000 in the next two years. In order to lock this right, the potential investor will have to make a down-payment to the developer. This down payment is however not refundable. This non-refundable down-payment is the price of the option contract. This price will vary depending on the developer. We can assume that the investor makes a deposit of $15,000. If the specified time (i.e., 2 years) elapses, and all necessary designs have been made on the property, the investor then exercises his option and buys the home at $300,000, since that is the contract agreed on. If the market value of that home doubles to $600,000, the investor will still buy it at the agreed $300,000, because that is the down payment locked in a pre-determined price. However, if the approval does not come through until the third year, the investor must pay the market price because the contract has expired (by an extra year). The developer keeps the original $15,000 collected.

Another example, Amazon stock is trading at $ 1870 per share, an investor can buy the option of Amazon stock for less to own the right to the stock for a period of time. This means the investors is just renting the stocks and he or she does not own the stock.

But what the investor gets is the right to make money with the stock for a short period of time; he or she must give it back when the rental expires. Case Study: Regular stocks have it's own pricing while stock options also have its own pricing. Stock options are sold per contract, and at 100 shares per contract. Therefore, to rent 100 shares of Amazon stocks, the buyer must pay the premium to own it. Most investment platforms will provide the price. For example, Amazon stocks at 1800 per share for 2 years may cost about $28,000 to rent instead of paying ( 100 * $1870 = $187,000). Instead of paying $187,000 to own the stocks of Amazon; the investor only pays $28,000 to use the stock for a period of 2 years. If the stock goes up by $50 the investor will make $5000 (50 * 100 shares of Amazon), minus fees.

As you can see, the investors can reduce the risk of investing $ 187,000.00 on Amazon stock by just wagering $28,000 and but the investor makes money as if he owns the stock.

Put Options

Put options give an individual the right to sell a security at a specified price during a specified period of time. Put buyers are generally bearish on the market, so they purchase puts to try and profit from an expected downside move. This is similar to shorting the stock because the trader is motivated by expectations that the shares will fall below a certain price. 

Imagine this scenario for a put option. An investor can insure his/her S&P 500 index portfolio, by purchasing put options. If an investor is scared that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index and the S&P 500 is currently trading at $3500, he/she can purchase a put option giving the right to sell the index at $3250, at any point in the next two years.  If in six months a 20% market crash occurs (700 points on the index), he or she has made 250 points by being able to sell the index at $3250 when it is trading at $3000, which gives a combined loss of just 10%. Even if the market drops to zero, the loss would only be 10% if this put option is held. 

An example or Case Study of a Put option: Please see the Amazon stock example above under the Call option, but the transaction will be opposite in this sense. Meaning, we are investing to make money when the market loses money.

Option Contacts

When an investor purchase options, the price quoted will be per share and not per contract. A calculation will be made using the formula below.

[Number of contracts x price per contract x 100= Total cost of trade (Premium).]

Purchasing an option contract involves paying a premium for the privilege that goes along with holding that contract and not paying for the full value of a stock. 

Types of options contract include:

• Options at the Money

Options at the money occur if the strike price is the same as the market price of the underlying security. For instance, if Apple is trading for $420 and you hold a May 420 option, you are “at the money" whether you own a call or a put.

• Options in the Money

A call option is “in the money” when the strike price is below the market price of the underlying stock. For a put option, a put is “in the money” when the strike price is above the market price of the underlying stock. For instance, if you buy an Apple May 420 call options now and two weeks later, Apple is trading for $423.00, then you are in the money by $3.00. 

• Options out of the money

A call is “out of the money” when an option’s strike price is above the market price of the underlying stock. For a put option, it occurs when the strike price is below the market price of the underlying stock. For instance, if you bought the May 420 call options a few weeks back, and Apple is now trading at $418, you would be out of the money by $2. May 415 put means you will be out of the market by $3.

Strategies for Trading Options

Several strategies for trading options exist and are briefly discussed below.

• Covered Calls

This strategy is employed to generate additional income on the position, with the hope that the option expires worthless (i.e., does not become in-the-money by expiration); enabling the investor to keep both the credit collected and the shares of the underlying. It also allows the investor to “lock in” some existing gains. The maximum potential gain for a covered call is the difference between the purchased stock price and the call strike price plus any credit collected for selling the call. 

• Cash-secured put strategy

It is an out-of-the-money strategy. The “cash-secured” part is a safety net for the investor and his broker because enough cash is kept on hand to buy the shares in case of an assignment.

• Option Spreads

Option spreads include basic credit and debit spread combined with puts or calls to yield a net credit (or debit) and create a strategy that offers both limited reward and limited risk. There are four types of basic spreads: credit spreads (bear call spreads and bull put spreads) and debit spreads (bull call spreads and bear put spreads). Credit spreads are opened when the trader sells a spread and collects a credit, while debit spreads are created when an investor buys a spread, paying a debit to do so. A bear call spread consists of one sold call and a further-from-the-money call that is purchased. The sold call is more expensive than the purchased, hence the trader collects an initial premium when the trade is executed. A bull call spread is a moderately bullish to neutral strategy for which the seller collects the premium, a credit when opening the trade. In the bear put spread, investors employ this option strategy by buying one put and simultaneously selling another lower-strike put, paying a debit for the transaction.