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12.1: What are Options Contracts?

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    79795
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    An options contract is a security that gives the holder the right to buy or sell a certain amount of an underlying financial asset at a specified price for a specified period of time. Options contracts are typically tied to stocks but any financial assets can be used as the underlying security. Options contracts are not investments. They are speculations which we already know to be a euphemism for gambling. Specifically, they are contracts between two market speculators. The buyer of the option contract gets the right to buy or sell the financial asset at a given price for a given period of time. If the buyer of the contract exercises the option, the seller of the option contract must buy or sell the asset according to the terms of the contract.

    Options contracts are part of a class of securities called derivatives. Derivatives are securities that derive their value from the price behavior of an underlying real or financial asset. Options contracts have no voting rights, receive no dividends or interest, and eventually expire. Their value comes from the fact that they allow the holder of the option to participate in the price behavior of the underlying asset with a much lower capital outlay. By the way, options contracts are usually just referred to as options. Just try saying, “options contracts,” three times fast.

    Options allow an investor to leverage their outlay of capital. As we’ve discussed, leverage is the ability to obtain a given equity position at a reduced capital investment, thereby magnifying returns. With options, you can make the same amount of money from a stock or other security as if you bought it for full price but only come up one-tenth or less of the money. Sounds too good to be true, huh? Well, you are right. It is too good to be true. Much of the time, you lose the entire outlay. Options have a time limit. Most options expire worthless.

    What is the Rationale for Options Contracts?

    You believe that a stock will do well and that the price will increase. Instead of buying the stock, you buy an option to buy the stock. Repeat: You don’t buy the stock; you buy an option to buy the stock. If the stock goes up, your option will go up almost always much, much faster and you can sell the option for a handsome profit. There is only one catch. The option expires in three, six or nine months. If the stock does not go up in that time period, the option will expire worthless. Surprise! Most options expire worthless. There are some scenarios where options can be worthwhile but they are few and far between.

    To make the whole concept even more confusing, there are options to sell a stock if you believe that the price of the stock will go down soon. In essence, you are gambling, ooops!, sorry, speculating that the price of the stock will either increase or decrease in the short term. Options have limited appeal to prudent, long-term investors. Buying and selling options is speculating. And we all know that speculating is just a fancy word for gambling.

    Let’s look at an example. There is a stock currently selling for $20 that you believe will do well. Say you buy a share of the stock for $20. If it goes up to $30, you have earned $10 on a $20 investment. That’s a 50% return on your money. Pretty good! But that’s not good enough for you. Instead, you buy an option to purchase a share of the stock at $20 currently selling at $20. The option might only cost you $1. If the stock goes up to $30, your option price will probably go up to around $11. You have earned $10 on a $1 investment! That’s a 1,000% return on your money. Whoa! That is “leverage” in action. Congratulations! Pat yourself on the back!

    Buying a Stock Versus Buying an Option to Buy a Stock

    But what if the stock price stays at $20 or goes down, even a small amount. Your option will expire worthless at the end of three, six, or nine months.

    But What Happens if the Stock Prices Does Not Go Up?

    And, of course, after your option expires, the stock price zooms to $40. You were so sure that this stock was going to hit the big time and you were absolutely right. But because you bought an option that expired, you lost the ability to share in the success of the stock. My advice? Forget about the option and just buy the stock! But since this is an Introduction to Investments class and textbook, we need to become proficient in the concepts, terms, and techniques of options. So…

    Calls Versus Puts

    There are two types of options contracts, call options contracts and put options contracts. Call options contracts are usually just referred to as calls and put options contracts are usually just referred to as puts. A call option contract is a negotiable security that gives the buyer of the option the right to buy the underlying security at a stated price within a certain period of time. The example above was a call option contract. When people talk about options, they are usually talking about call options unless they specify a put option contract. A put option contract is a negotiable security that gives the buyer of the option the right to sell the underlying security at a stated price within a certain period of time. It is the exact opposite of a call option.

    This is so confusing! Where did the terms ‘call’ and ‘put’ come from and how will I remember which is which?” The term “call” comes from the idea that when you buy a call option, you get the right to “call the stock away” from the seller of the option. The term “put” comes from the idea that when you buy a put option, you get the right to “put the stock to” the seller of the option. Get the idea? A “call” allows you to “call away the stock” from someone, buy it from them. A “put” allows you to “put the stock” to someone, sell it to them. Let us look at each in detail.

    Call Options and Put Options Explained, kinda', sorta', almost ... but they are really confusing ... and RISKY! Stay away from them!

    The Two Parties of a Call Option

    There are two parties to a call option, the option buyer and the option seller. To make options more confusing to the uninitiated, we also refer to the option seller as the option writer or option maker. The call option buyer is the person who will do the “calling away” of the stock. They have the ability to buy the stock from the call option seller if they choose to exercise the option. According to the terms of the contract, when they bought the option, they bought the right to exercise the option and buy the stock at the agreed upon price. Note the call option buyer is under no obligation to exercise the option. They can allow the option to expire worthless. Did we mention that most options expire worthless?

    The call option seller is the person who must sell the stock if the call option buyer exercises the option. The stock will be “called away from” from him or her. The call option seller is legally bound to sell the stock to the call buyer if the call buyer exercises the option. In return, they get the option premium, also called the option price, from the call option buyer. They get to keep the option premium no matter what happens.

    “What is the call option buyer hoping for? Why did they buy a call option in the first place?” The call option buyer is hoping that the price of the stock will go up. A call option buyer is bullish. If an option buyer has a call option to buy at $20 and the price goes to $30, the buyer can buy a $30 stock for only $20. More likely, if our intrepid call option buyer sees the value of their call option rise dramatically, they can simply sell the call option ‒ we say, “close out the transaction” ‒ before the option expires. Why bother actually buying the stock? With their profits, they can go buy another call option. The gambling, ooops!, speculating never ends!

    “What is the call option seller hoping for? Why did they sell the call option to the buyer?” The call option seller is hoping that the price of the stock will go down or stay the same. A call option seller is bearish or at least not very bullish. If the stock stays around $20 or goes down, the call option buyer will not want to exercise the option and it will expire worthless. If the call option buyer exercises the option, the call option seller is contractually required to see the stock to the call option buyer at the agreed upon price. In any event, whether the option is exercised or not, the call option seller gets to keep the price of the option.

    The graphic describes the two parties to a call option contract and their rights and responsibilities.

    The Two Parties of a Put Option

    A put option is the exact opposite of a call option. Everything is exactly the same except the put option allows the put option buyer to sell the stock instead of buy the stock. The put option buyer of the put options contract is the person who will do the “putting to” the put option seller. The put option buyer has the right to “put the stock to” (sell it to) the put option seller at the agreed upon price. Again, they do not have to exercise this right. That is why they are called options. Also, recall the majority of options contracts expire worthless.

    In a further effort to confuse outsiders, the seller of the put options contract is also called the put option writer or the put option seller. The put option seller of the option contract is the person who must buy the stock from the put option buyer. The stock will be “put to” them. The put option seller is legally bound to buy the stock from the put option buyer if the put option buyer exercises the option to sell. No matter what, they get the option premium, also called the option price, from the put option buyer.

    “What is the put option buyer hoping for?” The put option buyer is hoping that the price of the stock will go down. A put option buyer is bearish. If an option buyer has a put option to sell at $20 and the price goes to $10, the buyer can sell the $10 stock. They can “put it to the option seller” for $20. If the price of the stock goes down substantially, the put option buyer does not have to actually sell the stock. The put option buyer can sell the put option before the expiration date. This is called, “closing out the transaction.”

    “What is the put option seller hoping for?” The put option seller is hoping that the price of the stock will go up or stay the same. A put option seller is bullish or at least not very bearish. If the stock stays around $20 or goes up, the put option buyer will not want to exercise the option and it will expire worthless. In any case, the put option seller gets to keep the price of the option.

    The graphic describes the two parties to a put option contract and their rights and responsibilities.

    It’s Time for Questions about Options

    “Options are confusing, aren’t they?” Yes! In fact, the section on options is one of the hardest parts of the Series 7 Stockbroker exam. “Options sound like gambling. Am I right?” Yes! Options are a form of gambling. It is a zero-sum game. Someone wins, someone loses. A family acquaintance once called me and exclaimed, “Hey, Frank. I hear you can make a lot of money investing in options!” I said, “Wait a minute. Yes, you can make a lot of money; you can also lose a lot of money. But you can’t invest in options. You can speculate with options. You cannot invest in something that has a 60% chance of being worthless in three months! That is not investing.”

    “You keep saying that most options expire worthless. Well, just how many expire worthless?” That number is a subject of fierce debate. The percentage ranges from 10% to 90%, depending upon who is trying to present options in the best light or the worst light. The number that is most likely closest to the actual number is approximately 55% to 60%. If you want to explore the debate, just type “options contracts how many expire worthless” into your favorite Internet search engine. The management assumes no responsibility.


    This page titled 12.1: What are Options Contracts? is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.