Buy options or stock

Three Ways to Buy Options.

When you buy equity options you really have made no commitment to buy the underlying equity. Your options are open. Here are three ways to buy options with examples that demonstrate when each method might be appropriate:

Hold until maturity.

. then trade: This means that you hold onto your options contracts until the end of the contract period, prior to expiration, and then exercise the option at the strike price.

When would you want to do this? Suppose you were to buy a Call option at a strike price of $25, and the market price of the stock advances continuously, moving to $35 at the end of the option contract period. Since the underlying stock price has gone up to $35, you can now exercise your Call option at the strike price of $25 and benefit from a profit of $10 per share ($1,000) before subtracting the cost of the premium and commissions.

Trade before the expiration date.

You exercise your option at some point before the expiration date.

For example: You buy the same Call option with a strike price of $25, and the price of the underlying stock is fluctuating above and below your strike price. After a few weeks the stock rises to $31 and you don’t think it will go much higher - in fact it just might drop again. You exercise your Call option immediately at the strike price of $25 and benefit from a profit of $6 a share ($600) before subtracting the cost of the premium and commissions.

Let the option expire.

You don’t trade the option and the contract expires.

Another example: You buy the same Call option with a strike price of $25, and the underlying stock price just sits there or it keeps sinking. You do nothing. At expiration, you will have no profit and the option will expire worthless. Your loss is limited to the premium you paid for the option and commissions.

Again, in each of the above examples, you will have paid a premium for the option itself. The cost of the premium and any brokerage fees you paid will reduce your profit. The good news is that, as a buyer of options, the premium and commissions are your only risk. So in the third example, although you did not earn a profit, your loss was limited no matter how far the stock price fell.

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Options Basics: What Are Options?

Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does. The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. An options contract does not carry the same obligation, which is precisely why it is called an “option.”

Call and Put Options.

A call option might be thought of as a deposit for a future purpose. For example, a land developer may want the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws are put into place. The developer can buy a call option from the landowner to buy the lot at say $250,000 at any point in the next 3 years. Of course, the landowner will not grant such an option for free, the developer needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the premium, and is the price of the options contract. In this example, the premium might be $6,000 that the developer pays the landowner. Two years have passed, and now the zoning has been approved; the developer exercises his option and buys the land for $250,000 – even though the market value of that plot has doubled. In an alternative scenario, the zoning approval doesn’t come through until year 4, one year past the expiration of this option. Now the developer must pay market price. In either case, the landowner keeps the $6,000.

A put option, on the other hand, might be thought of as an insurance policy. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more than 10% of its value. If the S&P 500 is currently trading at 2500, he can purchase a put option giving him the right to sell the index at 2250 at any point in the next two years. If in six months time the market crashes by 20%, 500 points in his portfolio, he has made 250 points by being able to sell the index at 2250 when it is trading at 2000 – a combined loss of just 10%. In fact, even if the market drops to zero, he will still only lose 10% given his put option. Again, purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that period the premium is lost.

These examples demonstrate a couple of very important points. First, when you buy an option, you have a right but not an obligation to do something with it. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, however, you lose 100% of your investment, which is the money you used to pay for the option premium. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but options are actively traded on all sorts of financial securities such as bonds, foreign currencies, commodities, and even other derivatives.

Buying and Selling Calls and Puts: Four Cardinal Coordinates.

Owning a call option gives you a long position in the market, and therefore the seller of a call option is a short position. Owning a put option gives you a short position in the market, and selling a put is a long position. Keeping these four straight is crucial as they relate to the four things you can do with options: buy calls; sell calls; buy puts; and sell puts.

People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. This limits the risk of buyers of options, so that the most they can ever lose is the premium of their options. Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have unlimited risk , meaning that they can lose much more than the price of the options premium.

Don't worry if this seems confusing – it is. For this reason we are going to look at options primarily from the point of view of the buyer. At this point, it is sufficient to understand that there are two sides of an options contract.

Options Terminology.

To understand options, you'll also have to first know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date. In our example above, the strike price for the S&P 500 put option was 2250.

The expiration date, or expiry of an option is the exact date that the contract terminates.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. An option is out-of-the-money if the price of the underlying remains below the strike price (for a call), or above the strike price (for a put). An option is at-the-money when the price of the underlying is on or very close to the strike price.

As mentioned above, the total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and largely beyond the scope of this tutorial, although we will discuss it briefly.

Although employee stock options aren't available for just anyone to trade, this type of option could, in a way, be classified as a type of call option. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, exists only between the holder and the company and cannot typically be exchanged with anybody else, whereas a normal option is a contract between two parties that are completely unrelated to the company and can be traded freely.

The Basics Of Option Price.

Options are contracts that give option buyers the right to purchase or sell a security at a predetermined price on or before a specified day. They are most commonly used in the stock market but are also found in futures, commodity and forex markets. There are several types of options, including flexible exchange options, exotic options, as well as stock options you may receive from an employer as compensation, but for our purposes here, our discussion will focus on options related to the stock market and more specifically, their pricing.

Who's Buying Options and Why?

A variety of investors use option contracts to hedge positions, as well as buy and sell stock, but many option investors are speculators. These speculators usually have no intention of exercising the option contract, which is to buy or sell the underlying stock. Instead, they hope to capture a move in the stock without paying a large sum of money. It is important to have an edge when buying options.

A common mistake some option investors make is buying in anticipation of a well-publicized event, like an earnings announcement or drug approval. Option markets are more efficient than many speculators realize. Investors, traders and market makers are usually aware of upcoming events and buy up option contracts, driving up the price, costing the investor more money.

Changes in Intrinsic Value.

When purchasing an option contract, the biggest driver of success is the stock's price movement. A call buyer needs the stock to rise, whereas a put buyer needs it to fall. The option's premium is made up of two parts: intrinsic value and extrinsic value. Intrinsic value is similar to home equity; it is how much of the premium's value is driven by the actual stock price.

For instance, we could own a call option on a stock that is currently trading at $49 per share. We will say that we own a call with a strike price of $45 and the option premium is $5. Because the stock is $4 more than the strike's price, then $4 of the $5 premium is intrinsic value (equity), which means that the remaining dollar is extrinsic value. We can also figure out how much we need the stock to move to profit by adding the price of the premium to the strike price (5 + 45 = 50). Our break-even point is $50, which means the stock must move above $50 before we can profit (not including commissions).

Options with intrinsic value are said to be in the money (ITM) and options with no intrinsic value but are all extrinsic value are said to be out of the money (OTM). Options with more extrinsic value are less sensitive to the stock's price movement while options with a lot of intrinsic value are more in sync with the stock price. An option's sensitivity to the underlying stock's movement is called delta. A delta of 1.0 tells investors that the option will likely move dollar per dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents on the dollar. The delta for puts is represented as a negative number, which demonstrates the inverse relationship of the put compared to the stock movement. A put with a delta of -0.4 should raise 40 cents in value if the stock drops $1.

Changes in Extrinsic Value.

Extrinsic value is often referred to as time value, but that is only partially correct. It is also composed of implied volatility that fluctuates as demand for options fluctuates. There are also influences from interest rates and stock dividend changes. However, interest rates and dividends are too small of an influence to worry about in this discussion, so we will focus on time value and implied volatility.

Time value is the portion of the premium above intrinsic value that an option buyer pays for the privilege of owning the contract for a certain period. Over time, this time value premium gets smaller as the option expiration date gets closer. The longer an option contract is, the more time premium an option buyer will pay for. The closer to expiration a contract becomes, the faster the time value melts. Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient market timing because theta eats away at the premium whether it is profitable or not. Another common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially. A clear exit strategy for being right or wrong should be set before buying an option.

Another major portion of extrinsic value is implied volatility – also known as vega to option investors. Vega will inflate the option premium, which is why well-known events like earnings or drug trials are often less profitable for option buyers than originally anticipated. These are all reasons why an investor needs an edge in option buying.

[ Eager to learn more about options? See real-life examples of options trades and learn how to apply smart options strategies to help the market work in your favor in Investopedia Academy's Options for Beginners course. ]

Buying Stock Using Stock Options.

Stock Options Are a Viable Addition to Some Investors' Portfolios.

When long-term investors want to invest in a stock, they usually buy the stock at the current market price and pay full price for the stock. One alternative to paying the full price at purchase is to buy it using margin. Basically, this is a 2:1 loan from your brokerage, allowing you, for example, to buy $1,500 worth of stock with an investment of only $500.00.

Another way to buy stock without investing the full amount of the purchase at the point of sale is to use stock options.

Buying stock options allows you to leverage your purchases far more than is possible in even a margined stock purchase.

Stock Options.

A stock option is a contract giving you the right -- but not the obligation -- to buy or sell an equity, usually a single stock, at a specified price. Options are time-limited, although the limits vary widely. If you do not exercise your right before the expiration date, your option expires and you lose the entire amount of your investment.

Stock options can be used to trade a stock for the short term, or to invest for a longer term. Since all options are time-limited, however, most options are used in the execution of a shorter-term trading strategy. Stock options are available on most individual stocks in the US, Europe, and Asia. Note that in contrast to the 2:1 leverage of margin trading in the stock market, option trading effectively leverages your investments at dramatically higher ratios.

This allows you to control a large amount of assets with only a small investment. It also dramatically increases your risk.

Buying Stock Using Stock Options.

When using stock options to invest in a particular stock, the reasons for investing in the stock may be the same as when buying the actual stock.

Once a suitable stock has been chosen, one common options trade is executed as follows:

Sell one out of the money put option for every 100 shares of stock Wait for the stock price to decrease to the put options' strike price If the options are assigned (by the exchange), buy the underlying stock at the strike price If the options are not assigned, keep the premium received for the put options as profit.

Advantages of Stock Options.

There are three main advantages of using this stock options strategy to buy stock.

When put options are initially sold, the trader immediately receives the price of the put options as profit. If the underlying stock price never decreases to the put options' strike price, the trader never buys the stock and keeps the profit from the put options. If the underlying stock price decreases to the put options' strike price, the trader can buy the stock at the strike price, rather than at the previously higher market price. As the trader chooses which put options to sell, they can choose the strike price, and therefore have some measure of control over the price they pay. Because the trader receives the price of the put options as profit, this provides a small buffer between the purchase price of the stock and the breakeven point of the trade. This buffer means that the stock price can fluctuate slightly before the price decline eventuates in a loss.

Another Example Trade.

A long-term stock investor has decided to invest in XYZ company. XYZ's stock is currently trading at $430, and the next options expiration is one month away. The investor wants to purchase 1,000 shares of XYZ, so they execute the following stock options trade:

Sell 10 put options (each options contract is worth 100 shares), with a strike price of $420, at a price of $7 per options contract. The total amount received for this trade is $7,000 (calculated at $7 x 100 x 10 = $7,000). The investor receives the $7,000 immediately and keeps this as profit.

Wait for XYZ's stock price to decrease to the put options' strike price of $420. If the stock price decreases to $420, the put options will be exercised, and the put options may be assigned by the exchange. If the put options are assigned, the investor will purchase XYZ's stock at $420 per share (the strike price that they originally chose).

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If the investor does buy the underlying stock, the $7,000 received for the put options will create a small buffer against the stock investment becoming a loss. The buffer will be $7 per share (calculated as $7,000 / 1000 = $7). This means that the stock price can fall to $413 before the stock investment becomes a loss.

If XYZ's stock price does not decrease to the put options' strike price of $420, the put options will not be exercised, so the investor will not buy the underlying stock. Instead, the investor will keep the $7,000 received for the put options as profit.

Conclusion.

Options have other uses beyond the scope of this article. In several investment situations, however, it may make sense to invest in options rather than the underlying stock. Note, however, that the basic fact of option trading -- that you are highly leveraging your investment -- inevitably means your risk is similarly greatly increased.