Options for Newbies – Part 2

Russ Allen

In this series, on alternate weeks, I’m going to go through the subject of options in the most basic way. Even if you’re a veteran, these articles may give you a deeper understanding of some aspects of options than you had before.

Last time, in the article you can review here, we introduced an example involving Call options on the stock of Apple Computer. As of that writing (August 29, 2012), Apple’s stock had closed at a price of $673.40. Among the many available call and put options, we looked at call options with a strike price of $650 and an expiration date of September 22. Those calls were selling for $27.60 per share, which was $2760 per contract.

Let’s see how the buyers of these calls could make out:

Let’s say Apple were to make another new all-time high, and end up 23 days out $30 higher at $703.40. The call options at the $650 strike would then provide a discount (that is, has an intrinsic value) of $703.40 – $650, or $53.40 per share. Anybody who owned a $650 Apple call at that time could exercise it – that is, in effect turn it in to their broker, along with $65,000, and receive the hundred shares of stock. They could then immediately sell those hundred shares for $70,340. Let’s see, buy for $65,000 and sell at $70,340.  That’s a gross profit of $5,340. From that we have to subtract what we paid for the option, which was $2,760; leaving a net profit of $2,580. Ignoring commissions (which in this case would take a dollar or so out of our $2580), that’s about a 94% profit (2580 on 2760) in 23 days. This on a stock that itself increased only 4.5% (from $673.40 to $703.40).  That magnification of the profit (from 4.5% to 94%) is what we call leverage, and it’s one of the main attractions of options.

By the way, because we could exercise the options like this, doesn’t mean that we’d have to in order to realize our profit. We don’t need to suffer the inconvenience of parting with $65,000, even temporarily, if we don’t want to.  Those options can be bought or sold online instantly with a few mouse clicks. Since anybody who owned that option could use it to get that $53.40 per share discount, we knew there would  be people bidding just a few cents less than that amount at the close of business on expiration day. That few cents is a risk-free profit to them. So we could just sell our option to one of them for $5,340 less a few dollars, and be done with it, profit in hand.

Sounds great, but what else could have happened?

Let’s say Apple had stayed right where it was for the next 23 days, so just before the close of the market on expiration day, the stock was still $673.40. The options would still give their owners the right to buy Apple at $650, which would still be a discount of $23.40. But that’s as good as it could ever get – there’d be no time left for things to improve. As on any expiration day, since there is no time left, there is no time value. At expiration, all  options, including these, are worth exactly their intrinsic value – the actual discount they provide, if any. In this case that’s still $23.40 per share. The option owners could have sold them for this amount and recouped the $23.40, so they’d be out the $4.20 they paid for the time value. Remember – when there is no time, there is no time value.

Not too bad – but how bad can it get?

What if some unimaginable disaster happens and Apple goes out of business in the next 23 days – its stock is worth nothing. In that case our right to buy nothing is worth nothing, so we will have lost the $2760 we paid for the option. Not good, but not as bad as if we had owned the $63,740 worth of stock itself. Our loss is only a small fraction of that – at worst; we can never lose more than we paid for the option. So the good news about owning options is that our loss is limited.  The bad news – what it’s limited to is 100% of what we paid for the options.

By the way, Apple doesn’t have to go to zero for call option owners to lose 100% of what they paid. All that needs to happen is for the stock to end up at expiration below the strike price ($650 here). In that case the right to buy something for $650, that is only worth $650, or $649.99, or any price at all less than $650, is worth nothing. If you had a coupon to buy toilet paper for $6.50, but the price on the shelf was $6.40, would you turn the coupon in? No, you’d just throw it away and pay the $6.40 For the same reason the option to buy at $650 would be worth nothing if the stock were at $640, with no time left for that to change.  In that case anyone who had paid $2760 for the option would lose the entire $2760. Remember the leverage? Here it’s worked against us. A drop in the underlying from $673.40 to $650, or just 3.5%, would cost us 100% of our investment. That is, if we waited that long. We don’t have to, as we’ll discuss later.

So if we were to lose our $2760, where would it go?  The answer is that it would have gone to the person who originally sold us the calls, when we paid for them in the first place. In this case our loss would be their gain.  If we had made money, they would have lost. In future articles we’ll describe this zero-sum-game aspect of options in detail.  One key to making money in options is deciding whether to make the bet or take the bet – whether to buy options or to sell them. Another is knowing which bet. That’s where we’re heading.

That’s all there is room for today. In future articles we’ll continue to lay out the basics for the new, not-so-new, and would-be options traders.

If you have questions or comments on this article, please contact me at rallen@tradingacademy.com.

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.