Options

As a buyer of a stock option you claim the right during a certain period to buy or sell the stock at a certain price. The one selling the option is called a writer. The writer has to deliver the stock to you if you do not sell your option before the expiry date. The writer has a commitment to sell or buy the stock from you.

The writer can not break the contract between you and him/her.

Example

The price for regular Microsoft stock is 100$ at the moment. You have the opinion that the stock will go up. You want to buy the stock but you do not have the money at the moment to buy 100 stocks. What a pitty ! . When the stock goes up you lose the profit potential.

Well with options you can buy an option to buy Microsoft stock at a fixed price of 100. So you do not buy the actual stock. The option is much cheaper.

Suppose the stock goes to 105 $ after you bought the option. You can still excercise your right to buy the stock at 100. And your profit if you sell them immideatly will be 500 $ (100 * 5) If the stock however goes down to 95 you do not have to excercise your option, you can let the option expire.

These option are "call options". These options give you the right to purchase the stock during a certain period for a certain price. Offcourse you have to pay a premium for this. But the premium is not the stock price but a fraction of it. The risc is that you have to let the Call expire. Your loss is the premium you paid.

So with a call option your are fixing the price of the stock to buy at !

What if you had 100 stocks in Microsoft. Everybody is saying the stock will go down, so you are in doubt to sell or not. What you can do now is to take the right to sell the stock at 100. If the stock goes down, do not dispear. You can still sell at the 100 price. Even if the stock goes down sharply you can sleep well !

This right to sell the stock at a certain price is called a "put option" . With these options you protect against the stock going down. You are selling againts the writer of the put option. Like with call options the periode in which you can excercise your right to sell is limited in time.

Properties of a Call- and put option

The underlying value

There are options on stocks, futures, currencies, indexes, etc. The commodity the option is working on is called the underlying value.

The amount of the underlying value

Normally stock options work on more then 1 stock. One option gives you the right to sell a fixed amount of shares or buy a fixed amount of shares. This is called the contract size. With stocks a very common size is 100.

The duration of the option

An option is limited in time. During this time period you have the right to buy or sell. The expiration date is given by a month. The option expires at the third friday in that month.

The strike price

The price at which you can buy or sell your stock is called the strike price. This price will not change during the duration of the option. This is also the price at which the writer has to deliver or sell the stock to the buyer of the option.

The combination of the 4 properties is called an option series. Lets have a look at some examples. For instance for Royal Shell:



A call for Royal dutch shell for a price of 45 euro is 25 cents. This means you can buy the option to buy shell at 45 for 25 cents. Size the size is 100 it will cost you 25 euros. The current stock price at this time was 42 euro.



A put for Royal shell at 45 euro cost 40 cents. This is the right to sell at 45 euro. All expirations are at may 20 2005.
Royal dutch is going down at the moment. It would not be that bad to buy a put at any price above 43.

The price of an option : option premium

For the requirement to sell or deliver the stock at a certain price the writer will ask for a compensation. This compensation is called the option premium.

The total value of the option can be calculated by multiplying the option premium with the contract size.

The premium is never fixed. It will vary daily. So this means you can also sell and buy the options and make profit on selling and buying options alone.

- When stock goes up, the call will be worth more and the put will go down in value.
- When stock goes down the call will loose in value and the put will gain in value.

Components of the option premium

The option premium is determined by two factors. The intrinsic value and the expectation value.

The intrinsic value = the difference between the strike price and the stock price. A call option has an intrinsic value when the price of the stock is higher then the strike price. A put option has intrinsic value when the stike price is higher then the stock price. A intrinsic value of an option can never be negative.

The difference between the intrinsic value and the option premium is called the expectation or time value.

When an option has intrinsic value the we call this an "Ïn the money" option. When the strike price is on or about the price of the stock is is called an "ät the money" option.

Applications

With options you can:

• fix the purchase price of a stock
• fix the sell price of a stock
• protect your stocks against a lowering of the price
• Make extra money on your investment in stocks.

1. Fix the purchase price of a stock

Suppose you want to but 100 stocks Microsoft at 100 dollars. You can do this in two ways.

1. Buy the stock. Pay 10.000 Dollars.
2. Buy an Call option at 100 at ta premium of 10 dollars. For a 2 months period. You pay 1000 dollars.

Now the stock during the call expiration period move to 120 dollars. You can exercise your right to buy the stock and sell immediatly. You make 2000 dollars. On an investement of 1000 dollars that is 100%. On the investement of the bought stock this is 10%. Investment is about percentages !

Suppose the stock goes down to 80 and your option expires. You lost 1000 dollars. But on the bought stock you lose 2000 dollars or 20%.

2. Fix a sell price of stock.

Suppose you have 100 stock Microsoft at 100 dollars. You are not sure about the future stocks price and decide to buy a put to sell at 100 dollars in 2 months time. When the stock goes down there is no problem. You exercise your right to sell at 100. What if the stock goes up: you lose your premium, but you still have the added value of the stock.

3. Protect yout stock agaist a lower price.

Like in 2. You have 100 Microsoft stock. But instead of excersiing your option to sell you sell the option itself. You still have the stock, but by selling the option you will cover your loses.

4. Make extra money on your investment in stocks.

You want to sell your microsoft stock at 120 dollars. At the moment the value is 100. If you write a call option at the stike price of 120 you will receive 10 dolars premium for this. If the stock at the expiration date is at 121 you probably have to sell at 120. But you made 10 dollars premium, so your real profit is 30 dollars !

If the stock goes down to 95 your call will not by excercised. (who want to buy at 120 if the stock value is 95?). Since yo have recieved 10$ premium you still have 5 dollars profit. so you are protected to a level of 90 before you start losing money !