Calls and Puts: Defining the Field of Play
Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. Some strategies are very high risk, but others are extremely conservative. This is what makes the options market so interesting. The variety of creative uses of options makes it possible to tie in profits in the most uncertain of conditions, or to pursue income opportunities without being exposed to even the most volatile markets.
Because the option is an intangible device, its cost is only a fraction of stock prices.
This ideaâusing intangible contracts to duplicate the returns you expect from wellâpicked stocksâis revolutionary to anyone who has never explored options trading. Most people are aware of the two bestâknown ways to invest money: equity and debt.
Equity InvestmentAn equity investment is the purchase of a share of stock or many shares of stock, which represents a partial interest in the company itself. Shares are sold through stock exchanges or over the counter (trades made on companies not listed on an exchange). For example, if a company has one million shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the company.
When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders. (Some special nonvoting stock lacks this right.) If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks, because they have tangible value, can be traded over public exchanges, or they can be used as collateral to borrow money.
ExampleEquity for Cash: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation.
ExamplePartway There: You buy an automobile for $10,000. You put down $3,000 and finance the difference of $7,000. Your equity is limited to your down payment of $3,000. You are the licensed owner, but the financed balance of $7,000 is not part of your equity.
Debt InvestmentThe second broadly understood form is a debt investment, also called a debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest, as a contractual obligation. The bestâknown form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders.
When you own a bond, you also own a tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today's market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have that advantage over stocks.
ExampleLending Your Money: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide any equity interest to you. You are a lender and you own a debt instrument.
ExampleHelping a Friend: A good friend wants to buy a car for $10,000, but has only $3,000 in cash. This friend asks you to lend him the balance of $7,000 and offers to pay interest to you. The $7,000 you contribute is a debt investment, and the interest you earn is income on that investment. When you act as lender, you have made a debt investment.
Options InvestmentThe third form of investing is less well known. Equity and debt contain a tangible value that we can grasp and visualize. Part ownership in a company and the contractual right for repayment are basic features of equity and debt investments. Not only are these tangible, but they have a specific life span as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless the company goes broke; a bond has a contractual repayment schedule and ending date. The third form of investing does not contain these features; it disappears â expires â within a short period of time. You might hesitate at the idea of investing money in a product that evaporates and then ceases to have any value. In fact, there is no tangible value at all.
Smart Investor TipOptions are intangible and have a limited life span. The main advantage is that options allow you to control 100 shares of stock without having to buy those shares.
These are some of the features of options. Taken alone (and out of context), these attributes certainly do not make this market seem very appealing. These attributesâlack of tangible value, worthlessness in the short term, and decline in value itselfâmake options seem far too risky for most people. But there are good reasons for you to read on. Not all methods of investing in options are as risky as they might seem; some are quite conservative because the features just mentioned can work to your advantage. In whatever way you might use options, the many strategies that can be applied make options one of the more interesting avenues for investors. The more you study options, the more you realize that they are flexible; they can be used in numerous situations and to create numerous opportunities; and, most intriguing of all, they can be either exceptionally risky or downright conservative.
Smart Investor TipOption strategies range from high risk to extremely conservative. The risk features on one end of the spectrum work to your advantage on the other. Options provide you with a rich variety of choices.
What is an Option?An option is a contract that provides you with the right to execute a stock transaction â that is, to buy or sell 100 shares of stock. (Each option always refers to a 100âshare unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the fixed price.
Since you can always buy or sell 100 shares at the current market price, you might ask: "Why do I need to purchase an option to gain that right?" The answer is that the option fixes the price of stock, and this is the key to an option's value. Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and also defines the risk to the market itself. As an option owner, the stock price you can apply to buy or sell 100 shares is frozen for as long as the option remains in effect. So no matter how much price movement takes place, your price is fixed should you decide to purchase or sell 100 shares of that stock. Ultimately, an option's value is going to be determined by a comparison between the fixed price and the stock's current market price.
A few important restrictions come with options:
- The right to buy or to sell stock at the fixed price is never indefinite; in fact, time is the most critical factor because the option exists for a specific time only. When the deadline has passed, the option becomes worthless and ceases to exist. Because of this, the option's value is going to fall as the deadline approaches, and in a predictable manner.
- Each option also applies only to one specific stock and cannot be transferred.
- Finally, each option applies to exactly 100 shares of stock, no more and no less.
The Call OptionSo each option applies to 100 shares, conforming to the commonly traded lot, whether you are operating as a buyer or as a seller. There are two types of options. First is the call, which grants its owner the right to buy 100 shares of stock in a company. When you buy a call, it is as though the seller is saying to you, "I will allow you to buy 100 shares of this company's stock, at a specified price, at any time between now and a specified date in the future. For that privilege, I expect you to pay me the current call's price."
Each option's value changes according to changes in the price of the stock. If the stock's value rises, the value of the call option will follow suit and rise as well. And if the stock's market price falls, the call option will react in the same manner. When an investor buys a call and the stock's market value rises after the purchase, the investor profits because the call becomes more valuable. The value of an option actually is quite predictable â it is affected by the passage of time as well as by the everâchanging value of the stock.
Smart Investor TipChanges in the stock's value affect the value of the option directly, because while the stock's market price changes, the option's specified price per share remains the same. The changes in value are predictable; option valuation is no mystery.
The Put OptionThe second type of option is the put. This is the opposite of a call in the sense that it grants a selling right instead of a purchasing right. The owner of a put contract has the right to sell 100 shares of stock. When you buy a put, it is as though the seller were saying to you, "I will allow you to sell me 100 shares of a specific company's stock, at a specified price per share, at any time between now and a specific date in the future. For that privilege, I expect you to pay me the current put's price."
The attributes of calls and puts can be clarified by remembering that either option can be bought or sold. This means there are four possible permutations to option transactions:
- Buy a call (buy the right to buy 100 shares).
- Sell a call (sell to someone else the right to buy 100 shares from you).
- Buy a put (buy the right to sell 100 shares).
- Sell a put (sell to someone else the right to sell 100 shares to you).
Another way to keep the distinction clear is to remember these qualifications: A call buyer believes and hopes that the stock's value will rise, but a put buyer is looking for the price per share to fall. If the belief is right in either case, then a profit may occur.
The opposite is true for sellers of options. A call seller hopes that the stock price will remain the same or fall, and a put seller hopes the price of the stock will rise. (The seller profits if the option's value fallsâmore on this later.)
Smart Investor TipOption buyers can profit whether the market rises or falls; the trick is knowing ahead of time which direction the market will take.
Making Profit with OptionsIf an option buyer â dealing either in calls or in puts â is correct in predicting the price movement in the stock's market value, then the action of buying the option will be profitable. Market value is the price value agreed upon by both buyer and seller, and is the common determining factor in the auction marketplace. However, when it comes to options, you have an additional obstacle besides estimating the direction of price movement: The change has to take place before the deadline that is attached to every option. You might be correct about a stock's longâterm prospects, and as a stockholder you have the luxury of being able to wait out longâterm change. However, this luxury is not available to option buyers. This is the critical point. Options are finite and, unlike stocks, they cease to exist and lose all of their value within a relatively short period of timeâwithin a few months for every listed option. (Longâterm options last up to three years; more on these later.) Because of this daunting limitation to options trading, time is one important factor in determining whether an option buyer is able to earn a profit.
Why does the option's market value change when the stock's price moves up or down? First of all, the option is an intangible right, a contract lacking the kind of value associated, for example, with shares of stock. The option is an agreement relating to 100 shares of a specific stock and to a specific price per share. Consequently, if the buyer's timing is poorâmeaning the stock's movement doesn't occur or is not substantial enough by the deadlineâthen the buyer will not realize a profit.