Options: How Options Work
To see how options work, we'll use an example. Let's say that on May
20th, the stock price of IBM is $100 and the premium (cost) is $5 for a July
110 Call, which indicates that the expiration is the 3rd Friday of July and the
strike price is $110. The total price of the each contract (100 shares) is $5 x
100 = $500. In reality, you'd also have to take commissions into account, but
we'll ignore them for this example show how it works. Remember, one stock
option contract is the option to buy 100 shares; that's why you must multiply
the contract by 100 to get the total price. The strike price of $100 means that
the stock price must rise above $100 before the call option is worth anything;
furthermore, because the contract is $5 per share, the break-even price
(neither profit or loss) would be $105.00. When the stock price is $100, it's
less than the $110 strike price, so the option is worthless because in order
for this option to have intrinsic value, it must be above be above the strike
price of $110. But don't forget that you've paid $500 for the option, so
you are currently down by this amount.
Three weeks on June 11th, the stock price rise to $120. The options
contract has increased along with the stock price (but not dollar for dollar)
and is now worth $15 x 100 = $1,500. You tripled your money in just three
weeks! Subtract what you paid for the contract, and your profit is ($15 - $5) x
100 = $1,000. You could sell your options, which is called closing
your position, and take your profits--unless, of course, you think the
stock price will continue to rise.... then you can wait until it expires to
close the position. Its important to remember that, the price of the option do
not increase or decrease dollar for dollar with the price of the stock
Let's say by the expiration date, the price tanks and is now at
$105. Because this is less than our $110 strike price and there is no time
left, the option contract is worthless and you have lost $500 you paid to the
option seller. To recap, here is what happened to our option investment:
|
Date |
May 20th
|
June 11th
|
Expiration Date
|
|
Stock Price |
$100
|
$120
|
$105
|
|
Option Price |
$5
|
$15
|
worthless
|
|
Contract Value |
$500
|
$1,500
|
$0
|
|
Paper Gain/Loss |
$0
|
$1,000
|
-$500
|
Exercising Versus Trading-out
So far we've talked about options as the right to buy or sell
(exercise) the underlying. This is true, but in actuality a majority
of options are not actually exercised. In our example on June 11th,
you could make money by exercising at $110 and then selling the
stock back in the market at $120 ($10 net - $5 initial investment)
for a profit of $500 ($5 x 100). You could also keep the stock,
knowing you were able to buy it at a discount to the present value.
However, the majority of the time holders choose to take their
profits by trading out or closing out their position.
This means that holders sell their options in the market, and
writers buy their positions back to close. That's because when you
close out your positions before the expiration date, there is still
time value left and it is more profitable to close out the position
than exercising the option. In the same example above if you had
close out the position, you would have a profit of $1,000, but if
you exercise it you only make $500. There is $500 worth of time
value left in that option ($1,000-$500).
Option's Premium = Intrinsic Value and Time Value
It's important to know that an option's premium is its intrinsic
value + time value. Remember, intrinsic value is the amount
in-the-money, which, for a call option, means that the price of the
stock equals the strike price ($120 current stock price - $110
strike price = $10 intrinsic value). Time value represents the
possibility of the option increasing in value. So, the price of
the option in our example on June 11th can be thought of as the
following:
|
Premium = |
Intrinsic Value |
+ |
Time Value |
|
$15 |
$10 |
+ |
$5 |
Next-->>
What
Affects Option Prices?
|
