All About Options
An option is a marketable security that gives the holder the right, but not the obligation, to buy or sell another security at a specific price by a certain date. The essence of the option is that it's a bet; option holders are betting that the price of the underlying security will move as they expect, and as much as they expect. They don't necessarily care which way the price moves, as long as it moves. And though most people associate options with stocks (i.e. stock options), options can be written for virtually any kind of security that exists. However, since stock options are by far the most common, this chapter will focus on them.
Listed options are those that trade on the Chicago Board Options Exchange (CBOE) or another national options exchange. These options all come with fixed expiration dates and strike prices. In addition, every listed option represents a contract to buy or sell 100 shares of stock.
Before we get to the ins and outs, you need to learn the basic language of options. The two most important terms are put and call. A put option is for selling. A call option is for buying. Both types of transactions are carried out on the asset underlying the option. When you decide to buy or sell, you'll be exercising your option. The security price specified on the option is called the strike price. Long-term options are called LEAPS.
A stock option comes with a specific stock as the underlying asset. Stock options give you the right to buy or sell (depending on the type of option) a specific number of shares of named stock for a preset price within a preset time period. For example, you could buy a call option that would allow you to buy 300 shares of ABC Corp. for $50 one month from today. If the market price of ABC is $60 in a month, you would exercise your option and buy 300 shares of ABC at $50 (then turn around and sell them at $60 for a nifty $3,000 profit, $10 times 300 shares). On the other hand, if the stock price is only $45 next month, you would let your option expire. After all, why would you pay $50 for shares you could snap up for $45?
Investors can also create, or write, options, as opposed to buying them. In that case, the option writer offers someone else the opportunity to buy or sell an underlying security at a named strike price. If the option holder chooses to exercise the option, the writer is obligated to fulfill the options contract.
If you have an option, you have virtually unlimited profit potential, and your losses are limited to what you paid for the option. A stock option's value is determined by five principal factors: the current price of the stock, the strike price, the cumulative cost required to hold a position in the stock (including interest and dividends), the time to expiration (usually within two years), and an estimate of the future volatility of the stock price.
Some investors prefer a long-term view, and they may purchase longer term options known as LEAPS (long-term equity anticipation securities). LEAPS typically don't expire for two to three years, sometimes as long as five or ten years. Other than that key distinction, LEAPS trade like regular options.
Though they trade just like standard options, they are not as widely available. You can get them on most heavily traded stocks, but they are not written on as many different stocks as short-term options are.
Employee Stock Options
You may have heard about — or even received — employee stock options. These stock options are given by a company to its employees (usually top-level employees as part of their overall compensation packages) based on the company's own stock. In some industries, even lower-level employees may be offered stock options, especially in the fast-growing sectors like biotech. These options give employees the incentive to work harder and help make the company even more profitable. They are often used as an incentive to lure quality employees to the corporation.
The U.S. futures markets came about to help farmers stabilize grain prices, both in times of surplus and times of shortfall. That way, when crops are scarce (during the winter, for example), prices won't get prohibitively high. And when crops are plentiful, farmers won't have to sell their produce so low they can't buy supplies for the next year.
Employee stock options are different from regular options in that there's no third party writing the contract. Instead, it's a direct agreement between the issuing corporation and the option holder. In addition, employee stock options are often tax-advantaged, an added benefit for both the company and the employee. Another key difference is in the time frame under which these options can be exercised: Employee stock options usually must be held for a minimum time period (often more than a year) and can be exercised over long time periods, even as long as ten years.