3 things you must know about options

Puts and calls can be a great way to manage risk -- but beware of exploding sheep!

By InvestingAnswers Jun 11, 2013 3:09PM
Crystal ball copyright Brand X Pictures, JupiterimagesBy Tina Orem                                                                   

One of Johnny Carson's greatest characters was Carnac the Magnificent. Clad in a cape and giant feathered turban, the comic great pretended to prophesy the answers to secret questions. 

The act went something like this: Carson holds an envelope to his head, pretends to concentrate, and then sternly says, "Sis boom bah."

Then he opens the envelope and reads the question that prompted the answer: "What sound does a sheep make when it explodes?"
 
If only it were this funny and easy to predict the future values of investments. That's why people use options. Predict the future price of a security accurately, and you'll make far more money than just holding the security. Blow it, and you can at least limit your downside. 

It sounds easy, but before you put on your own feathered turban, here are a few things you need to know about options.

1. What are call options and puts -- and how do they work?
The most popular forms of options are puts and calls. A call gives the holder the right, but not the obligation, to purchase 100 shares of a particular underlying security (usually a stock) from the seller at a specified strike price (investinganswers.com) on the option's expiration date. Similar but different is the put, which gives the holder the right, but not the obligation, to force the other party to buy 100 shares of the underlying security.
 
As a quick example of how a call option makes money, let's say IBM (IBM) stock is trading at $100 per share. Now let's say you buy one call option on IBM at a price of $2 per contract. Note: Because each options contract (investinganswers.com) represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2 = $200).

Here's what will happen to the value of this call option under different scenarios:

When the option expires, IBM is trading at $105: Remember: The call gives you the right to purchase IBM at $100 per share. In this scenario, you use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. This option is therefore "in the money" (investinganswers.com). Because of this, the option will sell for $5 on the expiration date (because each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500). Because you purchased this option for $200, your net profit will be $300.

When the option expires, IBM is trading at $101: Using the same analysis as shown above, the call option will now be worth $1 (or $100 total). Since you spent $200 to purchase the option, you'll have a net loss of $1 (or $100 total). This option is "at the money" (investinganswers.com) because the transaction is essentially a wash.

When the option expires, IBM is trading at or below $100: If IBM ends up at or below $100 on the expiration date, then the contract will expire "out of the money." It'll be worthless, so you lose your money (in this case, the $200 you spent for the option).

In a put, the tables are turned. This position gives you the right to sell IBM shares at an agreed-upon price by a certain date. So, if the market price falls below the strike price, you can exercise your right to sell at the strike price. It's like having an insurance policy, because the writer of the contract has to buy the IBM shares from you. The profit is the difference between the cost of IBM shares in the open market and the strike price. 

2. How do options get their prices?
In our example, it costs $2 to buy an option. But why $2? Why not $5? Or $20? Well, the price of an option is a factor of the current price of the underlying security -- the IBM stock -- how long you have to exercise the option, how volatile IBM stock tends to be and the strike price. 

The most common way to calculate option prices is to use the Black-scholes model (investinganswers.com), named after Fischer Black and Myron Scholes, who developed it in 1973. 

The basic idea is to find the probability that an option will expire in the money. For example, if IBM stock is volatile, there is more potential for the option to go in the money before it expires. Also, the longer the investor has to exercise the option, the greater the chance the option will go in the money. Higher interest rates raise the price of the option because they lower the present value of the exercise price.

3. What is the witching hour?
As we've stated, options expire (usually at the end of a fiscal quarter), and sometimes many of them expire at the same time. Options and other kinds of derivatives -- index futures and index options, for example -- generally share simultaneous expirations on the third Friday of every month. 

So-called triple-witching days only occur on the third Friday of every March, June, September and December. We call the last hour of these trading days, from 3 to 4 p.m. EST, the triple-witching hour. 

On witching days, and especially during witching hours, many investors attempt to unwind their positions in their futures and options contracts before the contracts expire. As a result, stock prices can be volatile on these days, and you should anticipate that if you're going to dabble in options.

The Investing Answer: Despite the fact that there's always some guy in the investing world who is hawking "a sure thing," there is no way to predict the future price of any investment. Options can help nervous investors limit their downside risk when used properly. When used improperly, they can also carry tremendous -- even unlimited -- downside risk, which is why it is absolutely imperative to know a lot about options before investing.

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Tags: IBM
1Comment
Jun 12, 2013 8:14AM
avatar
You can lose sooo much in these options.  This article doesn't do one iota of explaining how you get screwed with when holding either puts or calls.  Sooo many of them expire worthless.  You need to really be confidence and recognize the right price. And understand the street will screw you sideways if they have half a chance.
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