12.2: Options Characteristics and the Breakeven Point
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The Strike Price, also known as the Exercise Price
The strike price is the contractually agreed upon price of the stock between the buyer of an option and the seller of the option. It is also called the exercise price. It is the stated price at which the call option buyer can buy the stock with a call option or the stated price at which the put option buyer can sell the stock with a put option. Options listed on the major exchanges traditionally sold in $2.50 increments for stocks selling for less than $25, $5.00 increments for stocks selling between $25 & $200, and $10.00 increments for stocks selling for greater than $200. However, pricing is more flexible now. There are many stock options that sell in $1 increments
The Expiration Date
The expiration date is the date at which an option expires. Traditionally, listed options always expired at the close of the market on the third Friday of the month of the option’s expiration date. The hour before the close of the market on the third Friday is sometimes called the “witching hour” as markets can exhibit heightened volatility from the unwinding of all the options about to expire. As well as stock options, there are also stock index options and stock index futures which we will discuss later. When all three – stock options, stock index options, and stock futures – expire on the same day, then it is called the “triple-witching hour.” To add to your options gambling, oh, I’m sorry, speculating enjoyment, there are now weekly options that expire every Friday. Why wait until the third Friday of each month when you can lose money each week?!
The Exercise Style
The exercise style describes how and under what circumstances the option can be exercised. American options can be exercised at any time before the expiration. European options can only be exercised at expiration. Normally, if you wanted to take a profit from an option that had done well and there was still significant time until the expiration date, you would simply resell the option instead of actually exercising the option. However, with an American-style option, if you really wanted to buy or sell the stock, you could exercise the option and buy or sell the stock before the expiration date. By the way, there are several other types of options with various provisions. An options seller who thought that he had created a fail-safe, risk-free options position was rudely disabused of that fantasy when one of the options was exercised long before the exercise date.
The Options Chain: How Options are Quoted
Options quotes are available from many free Internet websites. At Marketwatch.com, Yahoo Finance, CBNC or any other site, first search for the stock. At the [Summary] page, choose the [Options] menu choice. The list of available options contracts and their prices for a particular security is called an options chain. Both Marketwatch.com and CNBC have an appealing method for displaying options. The call and put options are displayed next to one another. This is attractive on a larger screen but can be difficult to follow on a smaller screen device.
How Options Contracts Are Bought and Sold
We have discussed options contracts as if they were traded just as stocks are traded. In most ways, they are very similar but there is one major difference. Options are sold as contracts and each contract represents one hundred shares of the underlying stock. There are no odd-lots on the options exchanges. However, some market makers will facilitate old-lot contracts. So if the listed price of the option is $5, then one contract will cost $500, $5 * 100 shares. Two contracts will cost $1,000, etc.
The Option Premium, Also Called the Option Price
The option premium is the quoted price the option buyer pays to buy a listed put or call option. The option seller, also known as the option writer or option maker, receives the premium immediately and gets to keep it whether or not the option is ever exercised. (Did I mention that most options expire without being exercised? That most options expire worthless? Good! Just checking.) To make it even more confusing, the term premium is also used in a more precise manner when valuing options. For this reason, most people simply refer to the price of the option instead of the premium of the option.
Moneyness: “In-the-Money,” “At-the-Money,” “Out-of-the-Money”
A somewhat silly term used when discussed options is the “moneyness.” Is the option “in-the-money,” “at-the-money,” or “out-of-the-money.” This refers to whether or not it would be advantageous to exercise the option. An option buyer would want to exercise an “in-the-money” option. An option buyer would not want to exercise an “out-of-the-money” or “at-the-money” option. Let’s take a look at some examples.
A call option is “in-the-money” if the strike price, also known as the exercise price, is less than the market price of the underlying stock. In this situation, an option buyer would be able to purchase the stock for less than the current market price. For example, if the strike price were $50 and the market price of the stock were $54, then the call option buyer could exercise the option and buy a $54 stock for only $50. The call option would be said to be “$4 in-the-money.”
An “out-of-the-money” call option would have no value because the strike price exceeds the market price of the stock. This time, if the strike price were again $50 but the market price were only $47, the call option buyer would have no incentive to exercise the option. They would be buying a $47 stock for $50. The call option would be said to be “$3 out-of-the-money.”
As you might expect, the situation is reversed with put options. An “in-the-money” put option is a put option with a strike price greater than the market price of the underlying stock. If the strike price were $50 and the market price of the stock were $46, then the put option buyer can sell the stock at $50 that is currently selling for $46. The put option would be “$4 in-the-money.”
An “out-of-the-money” put option is a put option where the market price exceeds the strike price of the stock. Let’s say the put option strike price was again $50 but the current market price was $52. There is no incentive for the put option buyer to exercise the option since that would mean selling a stock at $50 that is currently selling for $52. The put option would be “$2 out-of-the-money.”
As the name implies, an “at-the-money” option has a strike price that is equal to the market price of the stock. With an “at-the-money” option, as with an “out-of-the-money” option, there is no incentive to exercise the option since the option buyer can buy or sell the stock at the same price as the strike price.
Moneyness and the Breakeven Point
The following graphic illustrates how the “moneyness” of a call option changes as the underlying stock price advances. With a strike price of $50, when the stock price is below the $50, the call option is “out-of-the-money” and the call option has no value. (There may still be some “time value” which we will discuss below.) Once the stock price advances past $50, the value of the call option begins to increase. It is now “in-the-money.” Theoretically, for every dollar past the strike price, the call option buyer gains a dollar and the call option seller loses a dollar.
However, the graphic above ignores the fact that the call option buyer had to pay for the option. If the call option price were $5, then the call option buyer would not actually see any payoff until the stock price rose to $55, the strike price and the price of the option. This is called the breakeven point for a call option buyer. The graphic below illustrates this relationship.
The fact that a call option buyer does not even start to make any money until the stock price reaches the breakeven point is yet another reason that options contracts are not suitable for the prudent, long-term investor. And, by the way, have you noticed we have not even included the cost of the commissions or the kickback that the brokerage firm receives from the transaction?
As you might expect and rightfully fear, the situation is completely reversed with put options. The graphic below shows what happens when the stock price falls below the strike price. The put option buyer starts to make money and the put option seller begins to lose money. The farther the stock price falls below the strike price, the more money the put option buyer will make and the more money the put option seller will lose.
But again, we ignored the option price. Let’s again use a put option price of $5. The put option buyer had to pay $5 for the right to sell the stock at the strike price of $50. The put option seller immediately receives the $5 as their compensation for writing the put option. This means that the stock must fall to at least $45, $5 below the strike price of $50, before the put option buyer starts to make money and the put option seller starts to lose money. Here, the breakeven point for the put option buyer is $45. Once the stock falls below $45, the put option buyer begins to make money on the transaction. The graphic below demonstrates this process.
The Time Value, Also Called the Time Premium
The time value, also known as the time premium, is the dollar amount by which the option price exceeds the option’s “in-the-money” value. In general, the longer the time to expiration, the greater the size of the time value. If an option is “out-of-the-money,” then the entire price of the option is due to the time value. In other words, an option that is “in-the-money” will sell for more than the amount it is “in-the-money” because of the time remaining until the expiration date. Often, an option that is “out-of-the-money” will still have time value. The option still has time to become worth more as the underlying stock price changes. In the theoretical call option “moneyness” graphic above, if the stock price were less than $50 and the call option were “out-of-the-money,” the call option might still sell in the options marketplace for above $0. The amount that it sold for would solely be attributed to the time value. Likewise, even in the theoretical put option “moneyness” graphic above, if the put option were “out-of-the-money,” it still might sell in the options marketplace for some amount. Again, that amount would be attributed to time value since no one would want to exercise an “out-of-the-money” option.
One last aspect of options deserves mention. Do not forget commissions! In the previous examples, we did not include the cost of the commissions. A commission is charged whenever an option is bought or sold. Both the buyer and the seller pay a commission when the contract is initiated. A commission is charged when and if the buyer exercises the option and buys or sells the stock and again, both the buyer and the seller pay a commission. A commission is also charged if the option buyer or option seller decides to “close out the transaction.” The option buyer can sell their option to another option trader. The option seller can buy the exact same call option, thereby canceling their position and handing over the seller’s responsibilities to another options trader. When you include the commissions, it makes it that much harder to make money in options. And if you are still somehow saying to yourself, “Well, I don’t pay any commissions with my broker so I don’t have to worry about that,” go back to chapter 3 and read about how your broker is receiving a kickback for every transaction you initiate.