Stock Options: An Introduction

  1. INTRODUCTION

In this article series, we will provide an overview of a financial instrument known as a stock option.  A stock option is a type of derivative security.  While derivate securities are often complex and opaque instruments, stock options are relatively straightforward.

This article will specifically focus on how enterprising investors who conduct bottom-up, valuation centered investment research can use stock options to magnify the returns of a mispriced stock.  Thus, we will discuss basic characteristics of options but not an explanation of option trading strategiesi.

  1. BASIC TERMINOLOGY AND CHARACTERISTICS OF STOCK OPTIONS

A stock option is an instrument which entitles the holder the right to buy or sell underlying stock at a specified price over a stated period.  For this right, the option buyer pays a premium, which is the price of the option contract.  The stated share price at which the option holder may buy or sell the underlying stock is called the strike price (or exercise price).

Option holders have three courses of action: they may sell the option, let the option expire, or exercise the option.

There are two exercise styles of options: “American” and “European”.  An American-style option gives the option holder the right to exercise the option anytime before the option’s expiration date.  The holder of a European-style option, in contrast, may only exercise the option at the option’s expiration.  Most stock options listed on U.S. exchanges are American-styleii.

2.1.  Stock Option Quotes and Trading Mechanics

Standardized stock options (those listed on an option’s exchange), can generally be bought or sold through any ordinary broker-dealer.  The broker-dealer will present an option “chain”, which is a presentation of options with different strike prices and expiration dates.  At a minimum, the presentation of options from a broker-dealer, or data service, will show the option’s expiration month, strike price, and premium.  More extensive option quotations may contain the option’s trading volume and open interest (number of outstanding options).

Like stocks, option prices will have both a “bid” and an “ask”.  An option’s bid is the highest price that someone is willing to pay for an option, while the ask is the lowest price that someone is willing to sell the option.

The option premium will be quoted for a single-share, but the option contract itself is for 100 shares. So, if the quoted option premium is, for example, $4, the position will cost the option buyer $4 x 100 = $400.

An organization known as the Options Clearing Corporation (OCC) serves at the center of all transactions in listed options.  Among the OCC’s most important functions is to act as the guarantor of all listed options, essentially eliminating the risk that a party in the option contract will defaultiii.  When a broker receives an order for an options transaction, the trade is routed to the OCC, which finds a counterparty to the transaction and matches the trade.

2.2.  Calls and Puts

The two basic types of options are call options and put options.

A call option grants the option holder the right to buy stock within a specified period.  A call option would be purchased by someone believing that the underlying stock’s price will increase beyond the call option’s strike price.  For example, suppose the current stock price for XYZ corp. is $20 and there are call options available which expire in six months, have a strike price of $23, and a premium of $2.  Further suppose that an investor believes that XYZ has an intrinsic value of $30 per share, and this value can be realized within the six-month period.  If the investor purchases stock in XYZ, her potential return is ($30 – $20) / $20 = 50%.  However, under the same scenario, the potential return on the call option is ($30 – $23 – $2) / $2 = 250%.  The return on the option is much higher than the return on the stock.  The ability of the investor to “lever” her return is part of the attractiveness of call options.  The call option, however, only offers the investor a return when the stock price exceeds the sum of the strike price and the premium.

A put option grants the holder the right to sell stock within a specified period.  Suppose in the above example, an investor owns stock in XYZ corp. at the current price of $20 per share.  This investor is concerned that some short-term event may drive the stock price down below $20, and she wants to protect her portfolio from this possibility.  Suppose that put options are available with a strike price of $19, a six-month expiration, and a $2 premium.  In other words, for a price of $200, the stock holder can sell 100 shares in XYZ at $19 per share at any time before the option’s expiration.  Thus, the XYZ stock holder is protected from a dramatic decline in stock price.  Note, however, that since the option has a cost of $2 per share, the put will only return a positive return if the stock declines below $17 per share (the strike price minus the premium).

2.3.  The Concept of “Moneyness”

Few options are ever actually exercised.  The trading of options ensures that any increase or decrease in the stock price will be reflected in the option’s premium.  Thus, the option holder can monetize her gain by simply selling the option.

An option has intrinsic value when its strike price is either higher (for a put) or lower (for a call) than the current stock price.  An option’s premium, however, will be higher than the option’s intrinsic value.  This is because the option has time value, or value attributed to the time remaining before the option’s expiration.  Thus, the option premium consists of intrinsic value and time value.

An option which has positive intrinsic value is known as being in-the-money.  For a call option, the option is in-the-money when the underlying stock’s price exceeds the option’s strike price.  For a put option, the option is in the money when the underlying stock’s price is below the option’s strike price.

An option is considered out-of-the-money when it has negative intrinsic value.  A call option is out-of-the-money when the underlying stock’s price is lower than the strike price.  A put option is out-of-the-money when the underlying stock’s price is higher than the strike price.

An option may also be at-the-money.  An option, whether call or put, is at-the-money when the underlying stock’s price is equal to the option’s strike price.

2.4.  Option Writing

An opening transaction is the initial trade of an option’s contract.  The sale of an option (either put or call) in an opening transaction is referred as writing the option, and the party selling the option is the option writer.  The option writer thus accepts the obligation to either buy or sell shares at the strike price should the option holder exercise the option.

2.5.  Option Payoffs

Option holders must be aware of the stock price at which they break-even, known as the break-even price.   The option holder will only profit when the stock price is above or below this price.  The break-even price for a call option is the strike price plus the option premium.  The break-even price for a put option is the strike price minus the option premium.

The most a holder of a call or put option can lose is the option premium.  The premium will be lost if the option expires.  The maximum gain for a call option holder is infinite, since a stock price can theoretically increase without limit.  For a put option holder, the maximum gain is the strike price minus the option premium, since the stock can only decline to zero.

For an option writer, the payoff is the exact opposite of that of the option holder.  In other words, the most a writer of a call option can make is the option premium, while accepting the possibility of unlimited loss.  For the writer of a put option, the maximum gain is the premium, while the maximum loss is the strike price minus the premium.

Sources:

Strong, Robert A.  Derivatives: An Introduction, 2nd ed.  Mason: Thomson, 2005

Olmstead, Edward W.  Options for the Beginner and Beyond.  Upper Saddle River:  FT Press, 2006

i For readers seeking a further understanding of options, the Options Industry Council (OIC) provides extensive and free education materials on its website at www.optionseducation.org

ii Index options, however, are European style.

iii The risk that a party in a financial transaction will fail to perform its contractual obligations is known as counterparty risk.

By |July 11th, 2017|Stock Options|

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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