put options. These two assets – calls and puts – are the building blocks for every
option strategy you will ever encounter. This is why it is crucial that you understand
the rights and obligations that they convey. Most confusion with option strategies
stem from not understanding (or simply forgetting) who has the right and who has
the obligation.
Because options are binding contracts, they are traded in units called
contracts.
Stocks are traded in shares; options are traded in contracts. An option contract, just
like a pizza coupon, will always be designated by the underlying stock it controls
along with the expiration month and strike price. For example, let’s assume we are
looking at a Microsoft June $30 call.
We’ll soon show you where you can look up actual option quotes and symbols for
options, but for now let’s make sure you understand what this option represents.
Using your understanding of pizza coupons, what do you suppose the buyer of
one contract is allowed to do? The buyer of this call has the right (not the obligation)
to purchase 100 shares of the underlying stock – Microsoft – for $30 per share at
any time through the third Friday in June. (Remember that the expiration date
for stock options is always the third Friday of the expiration month.) The buyer of
this coupon is “locked in” to the $30 price no matter how high Microsoft shares
may be trading. Obviously, the higher Microsoft trades, the more valuable the call
option becomes.
To understand this concept a little better, assume that you have found a piece
of property valued at $300,000 and wish to buy it. But you’d first like spend a few
days researching the area before buying it. If you do, you’ll run the risk of losing
it to another investor. What can you do? You can go to the broker and put down
some money to hold the property for you. For instance, you may pay $500 for
several days worth of time. If you decide against the property, you lose the $500.
These arrangements are done all the time in real estate and are called “options” on
real estate. Assume that you pay the $500 for five days worth of time and are now
locked into a binding agreement to buy the property for $300,000 over the next
five days. Now suppose that some news is spreading that the area is about to be
commercially zoned and some big businesses are interested in it. Property in the
area goes up dramatically overnight. But even if you decide to not buy the property,
don’t you think that somebody else would love to be in possession of the contract
that you have giving them the right to pay $300,000? Of course they would. And
these people will start offering you large amounts of money to persuade you to sign
over the contract to them. You could just sell it to them and they could sell it to
others. This is exactly what most traders do with the equity options market.
Now let’s go back to our option example. How much will it cost you to
use (exercise) your call option? Because you are buying 100 shares of stock, the
strike price must be multiplied by 100 as well. (The number “100” is called the
“multiplier” of the option for this reason.) If you were to exercise this Microsoft
$30 call option, you would pay the $30 strike * 100 shares = $3,000 cash. This is
called the
total contract value or the exercise value. In exchange for that payment,
you’d receive 100 shares of Microsoft. It works just like a pizza coupon. You pay
a fixed amount of cash and receive some type of underlying asset. Most brokers
charge a standard stock commission to exercise your options. If you exercised this
call, your broker would probably charge you his regular commission for buying
100 shares of stock. After all, the long call option is simply a means for buying
regular shares of stock.
To restate a previous point, it is important to understand that if you buy call
or put options, you are not required to ever buy or sell shares of stock. Further,
you do not ever need the shares of stock in your account at any time. Most option
contracts are opened and closed in the open market without a single share of stock
changing hands. Even though you're allowed to purchase or sell stock with your
options, most traders never do. Instead, they just buy and sell the contracts in the
open market amongst other traders.
Now let’s assume we are looking at a Microsoft June $30 put option. Think
about your auto insurance policy and try to figure out what this option allows
you to do. If you buy this put option, you have the right to sell 100 shares of
Microsoft for $30 per share at any time through the third Friday in June. Because
you are locking in a selling price, put options become more valuable as the stock
price falls. If you exercise this put option, you are selling 100 shares of Microsoft,
which means you will have 100 shares of Microsoft taken from your account and
delivered to someone else. In exchange, you will receive the $30 strike * 100 shares
= $3,000 cash. If you exercise this put, your broker will probably charge the regular
stock commission for selling 100 shares of stock since the put option is simply a
means for selling regular shares of stock.
What if you only wish to buy or sell fewer than 100 shares of stock? You can
do that but in a roundabout way. Using the call example above, let’s say you only
wanted to buy 60 shares of Microsoft for $30. You would still exercise the call
option for 100 shares and then immediately submit an order to sell 40 shares
(which would carry a separate commission). Each contract is good for 100 shares
and you must buy and sell in that amount. But there’s nothing stopping you from
immediately entering another order to customize those amounts to suit your needs.
Likewise, if you exercised a put option but only wanted to sell 60 shares of stock,
you would have to exercise the put and sell 100 shares and then immediately place
an order to buy 40 shares.
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