Stock options are not securities I recommend; However, it’s not unusual for someone to ask me about them.
There are two kinds of stock options – calls and puts. The buyer of a call option on a stock has the right to buy 100 shares of the stock from the seller for a fixed price, called the exercise price, until a fixed date, called the expiration date. The buyer pays the seller an amount called the premium. The buyer of a put option has the right to sell 100 shares of the stock to the seller at a fixed price until the expiration date for the exercise price.
The premium on an option depends on two factors: the option’s “intrinsic value” and the time until expiration.
The intrinsic value of a put option depends on the amount that the exercise price exceeds the stock’s current price. If the exercise price of a put option is $52 a share and the stock is trading at $50, then the option has an intrinsic value of $2 a share or $200. Even if the stock is at $52 a share, this put option will have value based on the time until expiration.
Let’s review several ways the options market is problematic for typical investors. The options market is not deep. For example, a stock like ExxonMobil may trade 9 million shares a day, while its options for a given exercise price and expiration date may trade a few hundred a day. This causes the bid-to-ask spreads to be much higher than for the stock, raising investors’ costs. Additionally, they are competing with skilled investors that use mathematical tools like a “Trinomial Tree” option value calculator to know a “fair” price for an option.
They are popular with speculative investors because, for a small amount of money, they can control 100 shares of an expensive stock. However, they can also be used to control risk.
Let’s look at two examples.
John bought 1,000 shares of Oracle stock (ticker: ORCL) years ago for $10 a share. He watched it go to $100 and cycle down to $82. He is concerned that it may continue to decline. How can he use puts to limit his risk? He can, for example, buy 10 September 16, 2022, $82.50 puts. The premium recently was about $6,780. John has limited his downside risk in Oracle through September 2022, to $6,780.
If John were optimism about Oracle but didn’t want to risk much money, he could use calls.
He could’ve bought 10 September 2022 $82.50 calls. He would’ve recently paid a premium of about $6,070. He has limited his downside risk to $6,070. If ORCL is trading above $82.50 on September 16, 2022, he can exercise his option and buy it at the “sale price” of $82.50. Alternatively, he could just sell his options for their intrinsic value.
More information is at cboe.com.
Note to Readers: I will be presenting a free Zoom seminar on April 7 from 11 am-noon titled “Prudent Investing in a Post-Pandemic World.” For reservations call 1-800-734-7171.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay. rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment advisor and is associated with Dow Wealth Management, LLC.