Okay in this post options trading 101 we are going to assume you understand the basic premise of options trading and have read our options trading glossary.
How Does Options Trading Work
The best way is to explain by example.
OK…..Lets say we see the price of ABC Holding is $67 on May 1st and the premium (cost) is $3.15 for a July 70 call.
What this means is that the expiration date is the third Friday of July and the strike price is $70. This means the total price of the contract is $3.15 x $100 = $315. In the real world you would also have to pay commission but in this example we will ignore that.
Now if you remember a stock option contract is the option to buy 100 shares. That is why we have multiplied the contract by 100 to get the price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything. Also as the contact is for $3.15 per share it thus makes our break-even price $73.15.
So when the stock price is $67, it’s less than the $70 strike price making the option worthless. However you have to remember that you have paid $315 for the option so you are currently down by that amount.
What Happens When The Price Shoots Up?
Now let us say that in four weeks the stock price has risen to $78. The options contract has increased along with the stock price so now is worth $8.25 x 100 = $825. Then when you subtract what you paid for the contract your total profit is ($8.25 - $3.15) x 100 = $510. Just like that you have almost doubled your money in just four weeks.
At this point you have the choice to sell the option which is called “closing your position” and take the profit there and then. The other alternative is to hold on to see if the price rises further. To explain options trading further in this example we are going to keep hold of our contract.
What Could Happen IF You Keep Hold Of A Contact
In our example we made the wrong decision we held on to our contract and the by the expiration date the stock was at a low of $62. This is bad because it is less than our strike price and there is no time left. We are now down the original price of the option which was $315.
To make it easier for both of us to understand I have put the calculations into a table:
Date | May 1 | May 28 | Expiry Date |
Stock Price | $67 | $78 | $62 |
Option Price | $3.15 | $8.25 | Worthless |
Contract Value | $315 | $825 | $0 |
Paper gain/Loss | $0 | $510 | -$315 |
What Does This All Mean?
The price swing for the length of this contract from high to low was a staggering $825 in just a few weeks. There was a point where the investment could have been an almost two-fold increase. This is leverage in action peeps.
Now let’s delve deeper into how options trading works in the real world. Yes we have talked about options as the right to buy or sell…..but in actuality the majority of options are not exercised. Let’s dig deeper shall we?
Exercising Versus Trading Out
When we look at our example we could have made money by exercising at $70 and then selling back at $78 for a net profit of $8 a share. We could also keep the stock in the knowledge that we are able to buy it a discount rate at the present value.
What happens in the real world is most holders choose to take their profit by trading out (closing out) their positions. The holder would sell his position on the option market with the writers buying back their position back to close it. Best estimates suggest that only about 12% of options are ever exercised, 58% traded out and the other 30% allowed to expire.
Let’s finish up this post and section by explaining pricing options in this example.
Intrinsic Value and Time Value
In our example the premium (price) of the option went from $3.15 to $8.25. This change can be explained by intrinsic value and time value.
In our example the premium (price) of the option went from $3.15 to $8.25. This change can be explained by intrinsic value and time value.
What we mean is an options premium price is its intrinsic value plus time value. Note the intrinsic value is the amount “in-the-money” an option is which for a call option means the price of the stock is equal to the strike price. The time value represents the possibility of the option increasing in value. In our example what this means is:
Premium = Intrinsic Value + Time Value
$8.25 = $8 + $0.25
In the financial world options pretty much always trade above their intrinsic value. In our example we just had to explain all possibilities that may happen when either buying or selling an option.
To learn more get our guide Options Trading For Dummies.
