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# Options for Newbies – Part 2

Russ Allen
Instructor

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.