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Read on, good people...
No one should ever invest in a market they do not understand. Before investing a penny in any market, it is essential we understand the risks, opportunities, rules and terms. Only then are we able to make the kinds of informed judgements necessary for success, and success in any market is all about judgement.
That said, let's consider the "O" word, Options.
While stock market trading has been around since recorded history, options have only been traded on a formal exchange since 1973. We do not have parents who were long time options investors, teaching us the ins and outs of the discipline. The "terms" used in these transactions are not familiar to many of us. This vocabulary has not been tapped nor captured by a very large segment of particularly small investors. (Peter Lynch asks what is the "small" investor, someone under 5 ft. tall?) I mean the inexperienced investor trying to increase his net worth in $100 to $5000 increments. Not to exclude those fat cats with a lot more, but this "smaller" group has been neglected and is missing some fruitful opportunities.
There must always be an edge of caution with the unknown (and a need for educated caution with the known). The result of the "unknown" element in options is a mystique, fueled by horror stories about money lost and how risky the options market is. The option market is risky, as is the stock market. The key to either success is knowledge, understanding what the risks are and in tilting the playing field in our direction. For instance, when I buy a stock, I don't know the price will go up. But if I buy when the price trend is favorable, the technicals suggest strong upward support, the fundamentals of the company convince me it isn't entering bankruptcy soon, and the real driver of market opinion, "News," has no clouds on the horizon, I will have improved my odds of a good return. That is not gambling, it's smart business!
That does not mean I will always be right. It means I will be right more times than I am wrong.
So, what does the term "option" mean? I purchased a home many years ago. Initially, I leased the home for x.$ per month with wording added to the contract: "the option to purchase the home anytime before the end of the lease for a y.$ price." I owned an option to buy the home at a specific price before the end of the contract. This example contains the elements of what we term an "option." It is a "right" secured by a legal piece of paper, in this case the lease/option contract. I then "owned" the right to exercise that option. If I chose to exercise the option, I would have to come up with the price agreed upon to purchase the home. If I chose not to exercise the option, upon expiration of the contract, it would expire worthless. I had paid for the right to "buy" the property for a specified price during the term of the lease, the cost of that option being included in the lease payments.
During the time of the lease, if property values skyrocketed up or drifted down, I could still buy the home for the agreed-upon fixed price as secured by the option. On the other hand, the owner, by receiving money for this option, was "obligated" to sell me the house if I exercised my "right" to buy it.
Terms:
1. Option: "A contract that permits its owner to buy or to sell an asset at a fixed price until a specified date."
The option is the contract, the piece of paper, giving its owner the "right" to buy or sell, for a certain amount of time. In the property example above, I, as the person paying the lease, could also arrange in the contract the right to sell my option to buy the home if I could find an interested buyer, and receive some commission or reward for finding the buyer. That is, I could treat the option as a commodity to sell for whatever the market would allow.
2. Call: "An option permitting the holder (its owner) the right to buy a specific asset at a pre-determined price until a certain date."
In any free-market transaction, there is always a buyer and a seller. The option can be bought or sold. The "call" option is an instrument giving its owner a "right" to buy an asset. In the case of the market, that asset will be a stock. When I "buy" a call, I have paid for the "right," but I am not obligated to purchase the stock. The person who sold me the option, the seller, by taking my money, is "obligated" to sell me the asset (stock) if I choose to exercise the option.
In the property example above I would be holding a "call" option since I had secured the right to buy the property. However, I was not obligated. The owner of the property was obligated to sell me the home if I chose to exercise the option. I did, he did. In the stock market, I can pay for the right to purchase a particular stock by buying a "call" option, giving me the right, for a certain time, to pay a specified price to buy the stock. Now why are we doing this?
We would only buy a "call" to purchase a stock sometime in the future if we thought its price would go up in the meantime. That is, if we could pay for the right to purchase a stock for $12.50 a share (the strike price) within two months when we felt it was going up to $15.00 in that time, that would be a good investment. If the stock did go to $15.00, we could buy it for $12.50, sell it on the market for $15.00 and pocket $2.50.
The price of purchasing a "call" in this example may be in the $1 to $2 range. We have controlled a large amount of the stock with a small amount of money. We are able to trade more expensive stocks investing a fraction of the price. Sound good? What is the down-side?
Because an option is a fixed-time investment, we lose whatever we paid for the call if it is not exercised by its expiration date. What if the stock does not go up as anticipated? Oops! What if the stock drops in price? Double oops.
3. Derivative:
"An asset that derives its value from another asset."
A call option on a stock is a derivative security that obtains its value from the shares of the stock purchased with the call option. All options are derivative securities. The market value of an option is affected by changes in the value of the underlying asset. What this means is the value of the option changes along with the value of the stock. The importance for us here is
understanding that a change in stock price is magnified in the price of the
option. A small change in the price of IBM can cause a large price change in a call option on that security. It is this "leveraging" feature that makes options trading such an attractive way to invest money.
An option price depends on two important factors, value and time. For example, Fore Systems Inc. (FORE) closed at $19.25 (19 1/4) on 1/7/99. A January call option for a $20 strike price was quoted at $0.63 (5/8). A February call option at the same $20 strike price was quoted at $1.94 (1 15/16). What do these different prices mean?
Quotes on FORE in the newspaper would look like this:
These two examples from the WSJ and IDB are exactly as shown in the paper. They only show a fraction of the option combinations available. They do not even show the same ones and are not easy to decode. We said that FORE closed on that date at 19 1/4. This appears under the name of the stock in the WSJ, and in the IDB after the term Close on the same line as the name of the stock. WSJ shows three call options: January $20 strike price with the contracts traded (3845) and the last quoted price for the option, 5/8 ($0.63); April $20, 690 contracts at 3 1/8 ($3.13); April $25 call, 423 contracts at 1 3/4 ($1.7). IDB shows us nine call options; three each for January, February and April.
Definition 3: All option contracts expire at the close of trading on the third Friday of a month. That is, a November option would expire at 4:30pm EST on 11/19/99.
Definition 4: Contract - Options are only purchased in "contracts," each contract representing 100 shares of the stock. "c" in the IDB version represents a "call option." The $17.50 January call option traded 111 contracts (11100 shares) at price of $2.25 on the day before.
We learn from these two newspaper examples that a $20 call option that expires on the 3rd Friday in January traded 3845 contracts the previous day and will cost us 5/8 ($0.625) per share, or $62.50 per contract. If we make this purchase, we have the right to buy how ever many contracts we paid for at $20 per share up till January 15th.
To summarize:
- An option is a derivative of an underlying stock, it derives its value from the stock.
- The price of an option changes as the price of the underlying stock changes.
- This price change is a magnified version of the change in stock price. Small changes in the stock price create large percentage changes in the option price. This is the good news.
- We can invest in high-flier big ticket stocks with a small amount of money (the Intel's, the Microsoft's, etc.). This is more good news.
- The "call" is the right to buy, or to call away a stock at a pre-arranged price within some fixed time.
- An option is a fixed time investment, that is, it expires! This is the bad news.
- We can be engaged in buying and selling options without ever taking
possession of the stock. (When approved for that level by our broker)
Remember, our objective is to reduce risk. There are really some exciting ways to do this with options.
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