Opening, Closing, Tracking: How It All Works
These are the four essential pieces you need to see the whole picture, to know which option is being discussed, and to distinguish it from all other options. In evaluating risk and potential gain, and even to discuss an option, every buyer and every seller needs to have these four essential pieces of information in hand.
To review the four terms:
- Striking price. The striking price is the fixed price at which the option can be exercised. It is the pivotal piece of information that determines the relative value of options based on the proximity of a stock's market value; it is the price per share to be paid or received in the event of exercise. The striking price is divisible by 5 points for stocks traded between $30 and $200. When shares trade below $30 per share, options are sold in increments divisible by 2.5 and other issues end up with fractional values after a stock split. Stocks selling above $200 per share have options selling at intervals divisible by 10 points. The striking price remains unchanged during the life of the option, no matter how much change occurs in the market value of the underlying stock. (When stocks split, both striking price and the number of shares have to be adjusted. For example, after a 2-for-1 split, a $45 option would be replaced with two options of $22.50, and the original 100 shares would be replaced with 200 shares of half the value.)
For the buyer, striking price identifies the price at which 100 shares of stock can be bought (with a call) or sold (with a put). For a seller, striking price is the opposite: It is the price at which 100 shares of stock will be sold (with a call) or bought (with a put) in the event that the buyer decides to exercise.
ExampleCall for a Strike: You purchase a call with a strike price of 25, which entitles you to buy 100 shares of stock at $25 per share, no matter how high the market price of stock rises before expiration date. However, the company announces a 2-for-1 stock split. After the split, you own two calls with strike price of $12.50.
- Expiration date. Every option exists for only a limited number of months. That can be either a problem or an opportunity, depending upon whether you are acting as a buyer or as a seller, and upon the specific strategies you employ. The LEAPS provides more time, thus more flexibility on the time limitation. It also commands a higher premium as a result. Every option has three possible outcomes. It will eventually be canceled through a closing transaction, be exercised, or expire, but it never just goes on forever. Because the option is not tangible, the potential number of active options is unlimited except by market demand. A company issues only so many shares of stock, so buyers and sellers need to adjust prices according to supply and demand. This is not true of options, which have no specific limitations such as numbers issued.
Options active at any given time are limited by the risks involved. An option far out of the money will naturally draw little interest, and those with impending expiration will similarly lose market interest as their time value evaporates. Buyers need to believe there is enough time for a profit to materialize, and that the market price is close enough to the striking price that a profit is realistic; or, if in the money, that it is not so expensive that risks are too great. The same considerations that create disadvantages for buyers represent opportunities for sellers. Pending expiration reduces the likelihood of out-of-the-money options being exercised, and distance between market price of the stock and striking price of the call means the seller's profits are more likely to materialize than are the hopes of the buyer.
ExampleExpiring Interest: You bought a put two months ago at striking price of 50. This put expires next week, but today the stock's market value is $55 per share. The put is five points out of the money and its current value is fractional. Unless the stock's market value falls within the next week, this put will expire worthless.
- Type of option. Understanding the distinction between calls and puts is essential to success in the options market; the two are opposites. Identical strategies cannot be used for calls and puts, for reasons beyond the obvious fact that they react to stock price movement differently. Calls are by definition the right to buy 100 shares, whereas puts are the right to sell 100 shares. But merely comprehending the essential opposite nature of the two contracts is not enough.
It might seem at first glance that, given the behavior of calls and puts when in the money or out of the money, it would make no difference whether you buy a put or sell a call. As long as expiration and striking price are identical, what is the difference? In practice, however, significant differences do make these two ideas vastly different in terms of risk. When you buy a put, your risk is limited to the amount you pay for premium. When you sell a call, your risk can be far greater because the stock may rise many points, requiring the call seller to deliver 100 shares at a price far below current market value. Each specific strategy has to be reviewed in terms not only of likely price movement given a set of market price changes in the underlying stock, but also how one's position is affected by exposure to varying degrees of risk. Some of the more exotic strategies involving the use of calls and puts at the same time, or buying and selling of the same option with different striking prices, are examples of advanced techniques, which will be explored in detail in Advanced Options Strategies.
ExamplePut Me Down for a Call: You have bought two options on two different stocks. The first one, a call, has a striking price of 25. When you bought it, the stock was at $23 per share, but today it has risen to $28. You can sell the call at a profit or exercise it and buy 100 shares at $25 per share. The second option is a put with a strike price of 45. When you bought it, the stock was at $47 per share and you believed the market value would fall. Now, close to expiration, the stock is still at $47 per share and your put has declined in value. The call value increases when stock value rises; and the put value increases when stock value falls.
- Underlying stock. Every option is identified with a specific company's stock, and this cannot be changed. Listed options are not offered on all stocks traded, nor are they available on every stock exchange. (Some options trade on only one exchange, while others trade on several.) Options can exist only when a specific underlying stock has been identified, since it is the stock's market value that determines the option's related premium value. All options traded on a specific underlying stock are referred to as a single class of options. Thus, a single stock might be associated with a wide variety of calls and puts with different striking prices and expiration months, but they all belong to the same class. In comparison, all of those options with the same combination of terms -- identical striking prices, expiration date, type (call or put), and underlying stock -- are considered a single series of options.
ExampleStuck with the Stock: You bought calls a couple of months ago in a pharmaceutical stock, in the belief that it would rise in value. You realize now that you picked the wrong company. The one on which you hold calls has been lackluster, but a competitor's stock has risen dramatically. You would like to transfer your calls over to the other company, but the rules won't allow you to do this. Every option is identified strictly with one company and cannot be transferred.
By Michael C. Thomsett