For about the next week I am taking some time off (a break from early retirement?WTF!). So today I’d like to introduce a Special Guest Post by John Ryan from Money Time Blog. You should definitely check out his site for all information related to money, investments, real estate, FI, and frugality (all things that I’m down with on this site). Be sure to follow him on Twitter @moneytimeblog and facebook
Today’s article is an introduction to options, a personal favorite area of investing for me. So without further adieu, enjoy:
The original writing can be found here
What Are Options?
It’s common in newspaper articles to read reference to writing calls, buying puts and tech companies offering lucrative stock options to employees. It’s easy to get bogged down in the terminology and be left scratching your head.
Options are an advanced topic, and not something you want to recklessly get involved in. It’s very worthwhile to understand what they are however.
History Of Future Markets
One of the oldest accounts of a future market is about Thales of Miletus, the 6th century BC Greek philosopher. Supposedly he got sick of being asked why, if he was so smart, wasn’t he rich. The story goes that based on the spring weather he predicted that it would be a good year for olive crops. He approached the various olive oil presses and pre-purchased their entire fall capacity. The people running the presses were happy to get the guaranteed money in the spring, instead of hoping for demand in the fall. When fall came and there were bumper crops of olives, Thales was able to sell his pre-purchased presses to olive growers for a premium and became wealthy.
In a nutshell, this is how future markets (including options) work. Someone is convinced of the future such that they’re willing to commit (for payment) to some future course of action. In this case the olive press owners committed their capacity to Thales in exchange for early payment.
Employee Stock Options
Employee stock options are perhaps the easiest to explain. A company give their employees stock options at a particular strike price. Say I work for Google and as part of my compensation they give me an option to buy up to 100 shares of Google stock at $500 per share. As of this writing, Google stock is worth $659.46, which means every share in my option is worth $159.46 (since I can buy it for $500 and sell it for $659.46 – this is called exercising your option). If I exercised my options, I would make $15,946.00 (100 times $159.46). If Google’s share price went open, the option would become more valuable. If Google’s share price went down, the option would become less valuable.
Employee stock options often have a vesting period, which refers to a length of time where options can not be exercised. If I was granted the stock option for Google with a 6 month vesting period, it means I can’t exercise them until that time is past. This is done to ensure I stay with the company – usually if you quit you lose unvested stock options.
This is why companies offer these. They act as “golden handcuffs” to keep employees working at the company. It also is intended to make the employee work harder, since a more profitable company will lead to a higher share price and will make them more money from their stock options.
Put and Call Options
Options just like the above can be traded on any major stock exchange. Two parties are needed, someone to write (create) the option, and someone to buy the option. The person who writes the option is acting like Google or the olive presses above, while the buyer is acting like Thales or the employee.
Say I was convinced that Google is over valued and I expected the share price to drop. I might write (create then sell) a CALL option on Google. This means that I’m committing to sell Google stocks for a period of time, say the next 6 months (this is called the expiration date). I would also choose a strike price, which is the price I’m committing to sell Google stock for. Say I set the strike price at $500. Finally it would need the number of shares I’m willing to trade, let’s assume it’s 100. This means, the person who buys the options from me can require me at any time (during the next 6 months) to sell them 100 shares of Google stock for $500 per share – a total sale of $50,000. If you bought this contract from me, you’d be in the same position as the employee above. At any time, you can exercise the option and immediately make the difference between the current stock price and the strike price, $159.46 per share as of this writing.
If we go to the NASDAQ, we can see the current value of such an option. $168.20 as of this writing. That means, to buy a call option for 100 shares of Google at a strike price of $500 with an expiration date of March 2016 would cost me $16,820.00 today. Clearly if I bought them for $16,820.00 then immediately excised them to make $15,946.00, I would be losing money – $874.00. The only reason I would buy this is if I expected Google to increase in value. If it did, I could then execute it and hopefully make money. Say Google goes up to $700.00 per share. I could then buy the 100 shares for $500 each, sell them for $700 each, making a profit of $20,000 on the 100 shares. Given that I paid $16,820.00 for the option, I would still be $3,180.00 ahead.
Say instead Google drops to $450.00 during the 6 months until the options expiration date. This would mean the purchaser would be losing money buying for $500 and selling for $450. This is where the name option comes from, the buyer has the OPTION to exercise it, but she’s not required to. In this situation, rather than buying the stock and losing money she would let it expire without exercising it, the person who wrote the option (me) wouldn’t have to sell her any stock and she’d be out the $15,946.00 paid for the option. I would still have the 100 shares of (now less valuable) Google stock at the $16,820.00 she paid me.
An extra twist is that someone who buys an option can turn around and sell that option to someone else. After the option is re-sold, the new buyer then deals with the person who wrote the option. The result of this is that options are rarely exercised. Instead they fluctuate in value based on the strike price and the stock’s current price. If someone wants to make money from an option, they’re more likely to sell it to someone else than to exercise it.
Put options work the exact same way, except that it is an obligation for the person who writes the option to BUY stock instead of sell it. Say I wrote an option saying I was willing to buy 100 shares of Google stock for $500 per share until March 2016. Currently I could sell such an option for $5.80 per share (again, according to NASDAQ). For the 100 shares, this means I’d get paid $580. The current value of exercising this option is the difference between $500 and the current share price, $659.46 or -$159.46 per share or -$15,946.00 for the 100 shares. Given that the option buyer would be losing money (buying for $659.46 and selling for $500), she would not want to exercise it today. This is why this option is sold so much cheaper than the call option. As long as Google’s share price is equal to or above $500, the person who bought the put option will let it expire without exercising it. HOWEVER, if Google’s share price dropped below $500, the person who bought the option could buy Google on the open market, then sell it to me for $500 per share. If Google dropped to $450 per share, they could buy then sell to me and make $50.00 per share, or $5000.00 for the 100 shares.
One way of viewing a put option is that it’s like insurance. For $580 the person who bought can “guarantee” that she can sell it for at least $500.00 – by selling it to me using the put option I sold her if it drops below $500.00.
In the Money and Out of the Money
You’ll sometimes see “in the money” or “out of the money” used in relation to options. These just refer to whether or not the option could currently be profitably exercised.
Have you ever bought stock options? Have you ever gotten employee stock options? How did either work out for you?