How options work
Like all financial products, options have their own terminology. It's important to understand it.
Basic vocabulary
Note: Usually a stock option contract is the option to buy 100 shares.
Holders: People who buy options are called holders.
Call: Option to buy.
Put: Option to sell.
Strike price: This is the cost of the underlying asset. It is set for a specific period or time. The expiration date is the third Friday of the specified expiration month. For example, a "June 60" call has a strike price of $60 and will expire on the third Friday in June.
Premium: The cost (price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value). Volatility is a measure for variation of price of a financial instrument.
Intrinsic value: The price of the underlying share less the strike price.
In the money: A call option is said to be in the money when the price of the underlying security is higher than the strike price. A put option is in the money when price of the underlying security is lower than the strike price.
Out of the money: A call option is said to be out of the money when the price of the underlying security is lower than the strike price. A put option is out of the money when the price of the underlying security is higher than the strike price.
At the money: An option is at the money when the price of the underlying security is equal or very close to the strike price.
The Cory's Tequila example
To illustrate how options work, let's take the case of a fictional firm called Cory's Tequila Company.
Let's say that:
- on May 1, the stock price of Cory's Tequila is $67. The premium (cost) is $3.15 for a July 70 call.
- the premium is $3.15. Since contract options is an option to buy 100 shares, the total cost of the contract is $315 ($3.15 x 100).
- the strike price of $70 means that the stock price must rise above $70 before the call option is worth anything. Furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.
- in reality, you'd also have to take commissions into account, but we'll ignore them for this example.
| Date | May 11 | May 212 | At expiry date3 |
|---|---|---|---|
| Stock price | $67 | $78 | $62 |
| Premium | $3.15 | $8.25 | $0 |
| Contract value | $315 | $825 | $0 |
| Paper gain/loss | $0 | $510 | -$315 |
Exercising versus selling
Right now, you could make money by exercising at $70 and then selling the stock back in the market at $78. So you exercise your stock option. In reality, very few investors do it; they prefer to close their position by selling their option on the derivatives market.
According to the Chicago Board Options Exchange (CBOE), about 10% of options are exercised, 60 are closed out and 30% expire worthless. The CBOE is North America's main options exchange.
Keeping your position open
On May 21, in the example above, you could also hold on to your contract if you think the stock price will continue to rise.
Intrinsic value and time value
How are option prices determined? In our example, the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.
An option's premium is its intrinsic value plus its time value.
Time value represents the possibility of the option increasing in value. The price of the option in our example can be thought of as the following:
| Intrinsic value | Time value | Premium |
|---|---|---|
| $8 | $0.25 | $8.25 |
In real life, options almost always trade above intrinsic value.
Useful link
TMX - Montréal Exchange: see the Options FAQ.
Tools and tips
Why use options?
Options are versatile securities that allow you to profit when a stock price falls (put options) or when it goes up (call options).
How to read an options table
What the columns in an options table stand for.
- When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.
- 3 weeks later the stock price is $78. The options contract is now worth $825 ($8.25 x 100). Subtract whet you paid for the contract, and your profit is $510 ($825 - $315). You almost doubled your money in 3 weeks. This is leverage in action.
- Suppose you keep your position open, but the price tanks and is now $62. Because this is less than our $70 strike price and there's no time left, the option contract is worthless. You're now down your original investment of $315.