What are Stock Options?
A stock option is: the right, but not the obligation, to buy a stock at a certain agreed upon price known as the “strike price”. What does this mean? Let’s say the price of Apple (AAPL) shares are currently going for $340 each. You expect it to go to $380 eventually but you only have $5,000 to invest. For that much, you can only afford
about 14 shares. If you bought at that price, and they did rise $40 to $380, you would have only gained a little more than $560 after broker’s commisssion and contract price, not to mention captial gains taxes. You would have risked $5,000 for a modest but decent 12% gain, but you risked $5,000 to make only $560. But with options you are essentially able to buy many more shares for the same money and potentially profit much more with (potentially) less risk. Let me tell you how this works.
How Call Options work
Go to an options price list for the stock ticker symbol you would be interested in. You can find this on Yahoo/Finance. If you were to pull up Apple’s stock ticker symbol AAPL, you would find a wide range of prices. With options, you are buying a contract that expires the third week of the month every month but you can get contracts that last 2 or three months. Without going into too much technicals, but still being responsible with the process, I will just say it is best to buy “in the money” call options. This will help you know the price we are looking for. I also recommend not the soonest expiration, but the next one. That would allow you about 2 months for your idea to solidify. On the price list, you will notice various amounts, these are the strike prices. This means if the current stock value as we mentioned previously is $340, you will see that as a strike price. If the options strike is the same as the current stock price that is considered “at the money”, if it is less it is “in the money” and safer because it covers you if the stock price drops during the term of the contract. If the price is above the current that is called “out of the money”, and are cheaper because they are more risky. Let’s say you realize you want to buy some Apple stock call options at the in the money $320 strike with the 2 month expiration.
That may cost you $25 based on the price shown, (I am just making this number up for our example here.) It is important to note that when discussing options, the price shown represents each, but must be multiplied by 100. That is because options can only be bought as groups of 100. The good news is you are about to control 100 shares of AAPL for less than $2,500 instead of 14 for $5,000. This process works in reverse as well, betting down the price instead of up (as with call options) and is referred to as “put options” or “puts”, and some people do complex functions of both referred to as “spreads”, or “condors”, etc. which are beyond the scope of this article.
Adding it all up
Let’s say you bought the options and within 2 months, and BEFORE the contract expires, the price went up to $380 as you had hoped; where as before you would have only made less than $560, now you gained $40 times 100 shares, which equals $4,000 (minus commission). But not so fast. You paid $2,500 for those options so you must subtract that from the total which leaves you with $1,500. Why? Because our definition was that you paid for the right to buy the shares at that price. But to make money with this you don’t want to “exercise” the option, meaning you would buy them outright. Instead you want to sell them. Essentially you instantaneously sell the stocks you don’t technically own, while simultaneously buying them at the agreed price. This allows you to complete the transaction without ever having to actually pay in full. Otherwise you would have to come up with $320 times 100 which is $32,000. even though you would sell them for $38,000 and after having paid $2,500 for the privilege (options price), you would net a profit of $1,500. Another way to calculate your gain is this: If the strike is $320 and the option price was $25, your stocks value has to rise above the total of those to in order to profit. In this case that would be above $345. In our example it was $380, which is $35 above. Multiply that by 100 and you made $3,500. It’s that simple, and you risked half as much money to make nearly 7 times as much! In the worst case scenario, it did not play out how you expected and the stock went down in value, rather than losing up to $5,000 as with stocks, with options you can only lose the amount paid for the option or priviledge, which in this example was $2,500. When this happens the contract or options expire worthless. Of course, this strategy is not intended to replace your retirement plan or even your investment portfolio, which should be properly diversified. This method should be considered something supplemental you do with your discretionary money. Some would consider this speculative investing. You would want to research company trends and fundamentals before getting into stocks or options. If you are well-informed and disciplined, you may find this to be a terrific opportunity to increase your overall portfolio’s performance.