I’ve discussed options briefly in the past, as part of my Investing 101 series. While they can be useful as a way to profit from market movements without owning the underlying stocks, they can get a bit tricky. To help you understand who profits from different option related situations, let’s go over a few examples. (Don’t worry, there’ll be pictures soon!)
Calling in the Profits
As you hopefully remember from the aforementioned Investing 101 post, calls are options that enable you to purchase shares of stock at a particular value (the strike price) at some point in the future. (Either at the expiration date, for European-style options, or at any time before or on the expiration date, for American-style options.) You might be tempted to assume that after you have bought a call option, all you need to do is wait for the price of the underlying stock to go above the strike price, exercise the option (that is, buy the stock at the strike price), and bingo, instant profit by buying at a discount.
Well, that’s not quite the way it works. In order to get someone to agree to sell you the stock at a particular, fixed value (which is known as writing a call), you have to give them an incentive (read: money). This is called the option premium. But that’s not the end; you also have to factor in the money you are paying to the brokerage in order to match you up with a call writer, the commission and other transaction costs. All told, the price for you to break even on your option transaction (and make as much profit as if you simply bought the stock and held it while it rose in value) is found like this:
Break-Even Price (Calls) = Strike Price + Option Premium + Commission and Transaction Costs
If the price of the stock when you exercise the option is between the strike price and the break-even price, you (our option buyer) will be able to buy the underlying stock for less than the current market price, but the savings you get will not be enough to make the whole process (buying the option, then exercising it and buying the stock) profitable for you. For a graphical representation, take a look at this (click the picture to expand it):
If we go from left to right across this chart (following the increase in stock prices) we see:
- Red: The call writer gets to pocket the option premium, and doesn’t have to part with his stocks. Good for him, bad for the call buyer.
- Yellow: The call is exercised (it is ‘in the money’, meaning the strike price is less than the market value) but the savings on the buyer’s part don’t cover the cost of the option. The call writer gets the strike price for the stocks, as well as some profit from writing the call, although not as much as if the stocks stayed below the strike price. The call writer’s profit decreases the further to the right you do in the yellow area. (Actually, because of the commissions charged by the brokerage, the far right area of the yellow section is one where neither the writer nor the buyer profit. As a result it’s possible for opinions to be a lose-lose proposition (at least for everyone but the brokerage).)
- Green: The call is exercised, and the total cost to the option buyer is less than the cost of purchasing the stock at the new, higher price. The buyer profits, and makes more profit the higher the stock price goes, while the call writer makes less profit than by holding and selling the stock outright.
Where are you Putting that?
Puts, in case you forgot, are essentially inverse calls; rather than allowing you to buy a stock at the strike price (regardless of the current market price), puts enable you to sell stock you own at a given price, regardless of the current market value. Buying a put is a way to profit when your stock goes down in price, without having to sell the stock and buy it back later. Of course, as with call options, puts have a premium and commission costs associated with them. However, because you expect the price of your stock to go down (or are trying to insure against such a fate), when calculating the break-even price, we need to subtract these costs from the strike price:
Break-Even Price (Puts) = Strike Price – Option Premium – Commission and Transaction Costs
It might seem a bit odd, if you’re used to regular stock investing, but when buying puts, the more the stock price declines, the more profitable the put becomes (as it forces the writer to buy the stocks at a much higher than current price). To see how this works in graphical form:
As you can see from this chart, the lower the stock price, the more profitable the put option. If we go from right to left:
- Green: Below the break-even point, the put buyer can force the put writer to buy the underlying stock at the strike price for more than current market value, also netting enough profit to more than cover the cost of the option. The buyer benefits, while the writer has to pay an overpriced amount for a declining stock.
- Yellow: The put is exercised and the put buyer can force the writer to buy the underlying stock for more than current market value, but not enough to cover the cost of the option. The further to the right you go, the more profit from the option premium that the writer gets to keep. (Again, the area right next to the green portion of the grid is one where, due to commissions, neither party will actually make a profit.)
- Red: Above the strike price, the put writer gets to both keep the premium and not have to buy the underlying stock. The put writer benefits, while the put buyer is out the option premium and commission costs.
One final point about options before we call it a day. You might be wondering why anyone would bother to buy options, when there are two areas of our graphs, the red and (most of) the yellow, where selling yields a profit. Well, there are several reasons; first, no matter how the stock price moves, the only profit you can get from selling options is the option premium. By way of contrast, when buying an option, you can get spectacular profits if the stock shoots into the stratosphere (with a call) or drops to nearly nothing (with a put). Second, if you find yourself on the wrong on of one of the aforementioned greatly profitable deals (and did not buy back your option), you could end up selling a spectacular stock for a song or forced to buy a crummy one for much more than market value; whereas the option buyer will only be out the option premium and commission costs if the trade breaks badly for him or her. Finally, if you are working with American-style options, all you need is one day when the option you sold goes into the green territory, and you can find yourself losing your profit.
What’s the moral here? Don’t underestimate the risk with options, particularly when selling them; unlike buying options, you’re abdicating your ability to control when (or if) the option is exercised, leaving you to the mercy of the option buyer. But don’t forget if you choose the buying path that you need to not only need to be concerned about the strike price, but also the break-even price.
Options aren’t for the lazy or weak of stomach; if you decide to invest in them, be sure you understand everything, including all the ways you could lose money (ESPECIALLY all the ways you could lose money) and only put a small portion of your portfolio at risk, at least until you become an options expert. (And even then, only use options when needed.) Good luck, and happy investing!