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Stock Options: A Form of Financial Free Agency? Part 1
by Richard P. Halverson

Financial options and free agency have some things in common. Both allow us to make choices. And both come with consequences for the choices we make. If we make good choices we benefit. If we make bad choices we pay a price. (Man, do I have to work hard to connect these financial tools to Mormon culture.) As with real agency, using it correctly takes proper understanding. This article is in two parts. The first part introduces a complex but important financial tool. Next month's part will deal with ways ordinary investors can take advantage of options.

Most people are familiar with the concept of an option when it comes to real estate. Let's say you have coveted your neighbor's cute little sixty room cottage for years. Finally, she agrees to sell it to you. You agree on a price, say $5,000,000. But first you have to make sure you can get the money out of your wife's piggy bank, and this may take you a month. You may give your neighbor an earnest money down payment to hold the property at that price for you for a period of time, say one month. Let's assume the earnest money is $100,000. This is like getting an option to buy the cottage. If you are not able to arrange the financing or you simply change your mind and fail to complete the deal before the month runs out, you lose your earnest money. Not only does your neighbor keep the $100,000, but she is also free to sell her cottage to someone else.

You can do the same thing with stocks. So, let's assume you have coveted your neighbor's cute little dot.com stock for years. Finally, she agrees to sell 100,000 shares to you. You agree on a price, say $50 a share or $5,000,000. But first you have to make sure you can get the money out of your wife's piggy bank, and this may take you a month. To hold the deal you may buy an option from your neighbor. You give her a small amount of money called a premium. Let's assume the premium is $1 per share or $100,000. If you are not able to arrange the financing or you simply change your mind and fail to complete the deal before the month runs out, you lose your premium. Not only does your neighbor keep the $100,000, but she is also free to sell her stock to someone else.

Difference between stock options and real estate
There are, of course, many differences between putting earnest money down on a piece of real estate and paying a premium to buy an option on a stock. First, is that in real estate the reason the buyer needs time is nearly always associated with getting financing. With stocks financing is almost never the reason. The reasons for stock options have to do with methods of building portfolios, time to see what the stock is going to do, arbitrage opportunities, methods of leveraging investment decisions, and many other highly creative and potentially rewarding strategies.

How Stock Options Work
The many uses of stock options have given rise to a huge and active market for these options. There are entire securities exchanges that do nothing but trade options. On most days the underlying number of shares being traded on options exchanges exceeds the shares being traded on regular stock exchanges. It is a tricky fast-paced world completely infested with its own set of rules and bewildering bafflegab. Still options are worth knowing about. Even ordinary investors can use options safely and profitably. But it is well to know how they work, because there are lots of ways to use them unsafely and unprofitably.

Mechanically buying and selling options is easy. You can do it with a phone call or a click of a mouse through a broker. But practically speaking, after you have made the call to your broker, you probably can not even place an order until you understand some of the basic terms.

An Example
If options can be hard to learn you are probably wondering why you should care. The next article will deal with some options strategies that you might use. But I will give just one example to spark your interest.

Assume you really are interested in a Dot.Com stock. Odds are you wouldn't really know if your neighbor owned it. But you could find it traded on stock exchanges. Assume you believe this company will be an Internet survivor. However, its price has plunged along with other Dot.Com stocks. You feel like the downtrend is about over, but you are not sure. Assume the stock is currently selling for $50. The stock also has options available and the 6-month at-the-money option is selling for $5. Assume you have $10,000 to invest.

Buy Stock

You buy 200 shares of stock.

Case #1. You are correct and the price soars to $75 over the next six months. You make $5,000.

Case #2. You are incorrect and the price drops to $25. You lose -$5,000.

Buy Options

You buy options giving you the right to buy 2,000 shares at $50 sometime in the next 6 months.

Case #1. You are correct and the price of the stock soars to $75 over the next six months. Your option will go from $5 to $25. You will make $40,000. (Eight times as much as in Case #1 above)

Case #2. You are incorrect and the price of the stock drops to $25. Your option will go from $5 to $0. You will lose -$10,000. (Twice as much as in Case #2 above and 100% of your investment.)

There can be a lot of leverage in options. You make a lot more money when you are right. And, conversely, you lose more when you are wrong.

There are also ways to use options to protect your investments, earn extra cash flow on stocks you want to hold and take advantage of price disparities you may find. More about strategies next time.

Learning the Lingo
In the mean time here is just a little bit of the basic bafflegab you will need to know just to understand what you are reading in the quotation section of the Wall Street Journal.

1. Option. A contract that gives the holder the right, but not the obligation, to buy or sell a specific security at a specific price and within a specific time. It is key to remember when you are trading an option you are trading the contract not the underlying security.

2. Call. An option to purchase a security. This might be thought of as calling the stock away from its current owner.

3. Put. An option to sell a security. This might be thought of as putting the stock to the individual on the other side of the transaction.

4. Premium. The price of the option. It is quoted per share and typically an option covers 100 shares. Thus an option with a quoted price of $1 will cost $100 to buy.

5. Buyer. The individual receiving and paying for the option.

6. Writer. An option seller who gives the option rights to the buyer. This person receives the premium.

7. Expiration date. The last day to excercise the option.

8. Strike price. The agreed upon price at which the security can be bought or sold. Also known as the exercise price.

9. Underlying security. The specific security covered by the option.

10. Underlying shares. The amount of shares of a stock that can be bought or sold under the option. Typically, each option contract is for 100 shares of stock.

11. Underlying value. The current market value of the stock covered by the option. The number of shares by the current market price. For example, 100 shares times a current price of $50 per share equals an underlying value of $5,000. The underlying value is neither the value of the option or the strike price value.

12. Naked option. An option where the seller does not own the underlying security.

13. Listed option. An option traded on an options exchange.

14. Arbitrage. Profiting from pricing disparities between related securities.

15. In-the-money. When the underlying security is selling above the strike price (or below in the case of a put.)

16. Out-of-the-money. When the underlying security is selling below the strike price (or above in the case of a put.)

17. Options exchange. An organized exchange trading options contracts.

18. Open interest. The number of option contracts open.

19. Implied volatility. The expected volatility or fluctuation of the underlying security.

An options contract must include several terms.

• It must specify what stock is covered - the underlying security.
• It must specify whether the holder is entitled to buy or sell the stock - call or put.
• It must specify how many shares - generally each contract is for 100 shares.
• It must specify at what price the holder can buy or sell the stock - the strike price.
• It must specify how long the option is good for - the expiration date.

When there are millions of investors who want to buy, sell and write these contracts on thousands of companies the terms must be standardized. It simply wouldn't be possible for all those investors to find each other and negotiate different terms. So the exchange does it for you.

They will open contracts for different time periods usually running from about 1 to 9 months. Very active companies may have a contract expiring every month. Other companies may have contracts expiring every three months.

They will open contracts with a strike price close to where the stock is currently selling. However, because the premium paid for an option is greatly affected by the movement of the underlying stock, they need to open new contracts as the stock fluctuates around. For example, there may be an option contract with a strike price of $50. If the price of the stock rises to $55 they will open a new contract with a strike price of $55. The old $50 contract is still there and being traded. Now, however, investors can choose from the $50 or the $55 contract.

In fact, investors will soon have many options contracts to choose from for the same stock. There are multiple months, for multiple strike prices and on multiple exchanges. It can add up to many hundreds of possible choices for a single actively traded stock.

In fact, there are so many option contracts, the Wall Street Journal doesn't even begin to try and list them all in the paper. They list only some of the more active ones. You can get the rest through your broker or from a number of on-line sources including the Wall Street Journal at WSJ.com. (You must subscribe.)

The Premium Price
The exchanges establish all the necessary terms when they open a contract except the premium. This is a very important term. The premium will be determined by trading activity just like anything traded on an exchange. There are three parts to premium price.

1. The strike price of the option relative to the price of the underlying security. If the stock is selling at $55 and the strike price is $50 the premium will be at least $5. This is because the holder can exercise the option, pay the option writer $50 and immediately sell the stock for $55. If the stock is selling at $45 or $5 below the strike price this portion will be $0.

2. Add to the price difference the time value of money for the underlying security. In theory, the writer of the option could do something else with the stock during the period of time you hold an option on it. At minimum, the writer could invest in treasury bills. So the premium will have something built into it to compensate for the time.

3. Finally, add to this the implied volatility. This refers to how volatile the underlying stock is. For example if the stock is trading at $45 and with a strike price of $50 it is currently trading out-of-the-money. The option may appear to be nearly worthless. However, if the history of this stock is that it bounces around 10% a day, the chances that it will bounce over $50 sometime in the next 6 months are pretty good. You will have to pay something for the option to find out. In fact, it doesn't even need a history of volatility. All it needs is for investors to believe it will rise above $50. Then the option will be worth something.

There are some fancy mathematical models that can calculate theoretical prices. If you ever decide to take options very seriously, you will want to become familiar with them. However, serious or not ,in real life you will find all the skill in determining the right premium to pay for an option is in figuring out the volatility component. The volatility fluctuates around as the news, fundamentals, markets, hopes and fears of the underlying stock change. Volatility defies mathematical accuracy just like the pricing of most types of securities defies mathematical accuracy.

One more important thing to remember about the premium on an option. There is a time decay. Every day the option is worth a little less than the day before. At least part of what the buyer is buying is the time to see how things are going to go. This wastes away to zero.

Stock options are like agency. They increase choices and that is good. There are ways to use options that increase or decrease risk. In the end, you will live with the consequences of the choices you make.

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