What it means
There are two basic types. A call option gives the right to buy shares at the fixed price, known as the strike price, and gains value when the share price rises.
A put option gives the right to sell shares at the strike price and gains value when the share price falls. The buyer pays the premium up front and can lose no more than that amount.
The seller, called the writer, receives the premium but takes on the obligation to deliver or buy the shares if the buyer exercises. This is why selling options carries far more risk than buying them.
Listed options on stock exchanges usually cover 100 shares per contract, so a premium quoted as $3 per share costs $300 per contract. The option has intrinsic value (the amount by which it is already profitable to exercise) and time value (the extra amount buyers pay for the chance of further movement).
Time value decays as expiry approaches. Employee stock options work on the same principle but are granted by the employer.
The employee may buy company shares at a fixed grant price after a vesting period, and gains if the share price has risen. For the company, these options are a form of pay, recorded as an expense, and when exercised they create new shares.
People use options for three main purposes: speculating on price moves with a small outlay, hedging an existing share holding against a fall and generating income by selling options. Each use has different risks, and a non-specialist should understand the maximum possible loss before trading.
In practice
Real-world examples.
Example
An investor expects a pharmaceutical company's shares to rise after a drug approval decision. She buys call options for a total premium of $2,000 rather than buying $40,000 of shares. If the approval is refused, she loses $2,000 instead of a much larger sum.
Example
A portfolio manager holds shares worth $5,000,000 and worries about a market fall over the next three months. He buys put options to set a floor under the value, paying a premium that he treats as insurance. If the market rises, he loses only the premium and keeps his gains.
Example
A technology company grants a new director 50,000 options with a strike price of $12, vesting over four years. If the shares reach $20, each option is worth $8 on exercise. The company records the cost of the option over the vesting period.
Formula
Calculation
Call option profit at expiry = (share price - strike price, if positive) - premium paid
An investor buys one call contract on 100 shares with a strike of $50 and pays a premium of $3 per share, so the cost is 3 x 100 = $300. At expiry the share price is $58. Intrinsic value = 58 - 50 = $8 per share. Profit per share = 8 - 3 = $5, so total profit = 5 x 100 = $500. The break-even price is 50 + 3 = $53, and if the share finishes below $50 the loss is limited to the $300 premium.Case study
Seen in the real world.
Pinecrest Software is an illustrative, fictional company that grants options to its engineers instead of paying market-level salaries. The strike price is set at $10, the share price on the grant date, and the options vest over four years.
Three years later the share price has risen to $25. An engineer holding 10,000 options exercises them, paying 10,000 x 10 = $100,000 and receiving shares worth 10,000 x 25 = $250,000, a gain of $150,000 before any tax.
The company issues 10,000 new shares, which dilutes existing shareholders slightly. The illustrative lesson is that options reward growth in the share price, but they cost existing owners a share of future value, and the cost should be tracked from the day of the grant.
Watch out
Common mistakes.
- Believing that buying an option is the same as owning the shares, when the buyer has only a right that expires and can become worthless.
- Forgetting that options lose time value every day, so even a correct view on direction can lose money if the move comes too late.
- Selling options without understanding the risk, when a seller of an uncovered call can face very large losses.
Questions
People also ask.
What is the difference between a call and a put?
A call gives the right to buy shares at the strike price and gains when prices rise, while a put gives the right to sell and gains when prices fall.
What happens if an option expires out of the money?
It expires worthless, and the buyer loses the full premium paid.
Are employee stock options the same as listed options?
They share the same basic idea of a fixed purchase price, but employee options are granted by the company, cannot usually be traded and usually have vesting conditions.
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