How Options Work (Options Investing: Part 1)

Part 1: How Options Work
Part 2: Stock Options vs. Stocks

My goal is to give you a basic understanding of how options work so that you can start using them as part of your investment portfolio. Many investors (especially when starting to learn about investing) dismiss the idea of investing using options because they think it is too risky.

In fact, I truly wish I had learned about investing using options much sooner. I will include an example towards the end of this post to bring it all together.

Are Options Risky?

Risk is relative when it comes to investing. Any investment carries risk. No risk, no reward. Investing using options should be no more risky than investing in a stock by purchasing shares.

You should always be thinking about how to minimize investment risk. If no investment is risk-free (excluding guaranteed investments), we simply need to answer “what is the safest way to invest using options?”

I always stick to one simple rule… buy options deep in-the-money.

While this is always my preference, it is not always financially possible for really expensive stocks. For this reason I will buy as far in-the-money as I can afford and generally buy no lower than at-the-money.

Understanding how options work should help you manage risk and give your portfolio a boost.

Types of Options

There are 2 common types of options and you need to know about both in order to understand how options work.

Call option = A bet that the underlying stock will increase in value.
Put option = A bet that the underlying stock will decrease in value.

The underlying stock refers to the investment on which you purchase the option, such as purchasing a call option on Apple’s stock.

Options Valuation Terms

Out-of-the-money: Stock Price < Option Strike Price
At-the-money: Stock Price = Option Strike Price
In-the-money: Stock Price > Option Strike Price

Intrinsic Value = Stock Price – Option Strike Price (once the option is in-the-money)

Time Value of Money = Option Premium – Intrinsic Value

Intrinsic value is the ‘real worth’ of your option. Time value decays over time and eventually hits zero at expiration (time decay).

How options work

All options have the following 3 main attributes:

Direction – call option (up) or put option (down).
Strike – the price at which the option can be exercised.
Expiration – the date on which the option expires (the more time to expiration, the more time value an option has). You must pay a premium for longer expirations because you have more time for your option to become profitable.

There are additional attributes that impact how options work such as volatility of the stock and whether the stock pays a dividend but as a long-term investor this generally washes out.

An options contract provides you with the right but not the obligation to control 100 shares of the underlying stock. You are allowed to exercise this right if your option is in-the-money on or before the expiration date.

Cost of an option contract = option premium * 100

Once purchased, the majority of option contracts are not exercised but instead either left to expire worthless or sold before expiration.

A real example…

… of how options work using the Apple call option that I am currently holding.

Direction – call option
Strike – $100
Expiration – Jan 20, 2017

I made a bullish bet that Apple’s stock will increase in price to at least $100. I bought the longest expiration possible because I generally invest longer-term. I wanted to be able to hold my option through the 2015 holiday season if I chose to do so. I paid a premium for this time value.

The premium for the call option at the time of purchase was $ 22 US, for a total cost of $ 2,200 US.

Cost of an options contract = option premium * 100
Cost of an options contract = $ 22 * 100 = $ 2,200

I purchased this call option when Apple’s stock price was trading around $106. This means I bought an option that was in-the-money.

In-the-money: Stock Price > Option Strike Price
In-the-money: $ 106 > $ 100

Intrinsic Value = Stock Price – Option Strike Price (once the option is in-the-money)
Intrinsic Value = $ 106 – $ 100 = $ 6

Time Value of Money = Option Premium – Intrinsic Value
Time Value of Money = $ 22 – $ 6 = $ 16

If I were to exercise my call option, I would need to pay 100 shares * $100 (the strike) = $10,000 US. Upon exercising my call option, my position would be immediately profitable just as my call option is currently profitable (Apple’s stock closed today just under $127).

Instead, I will eventually sell my option before expiration.

Note: A call option does not have to be in-the-money to have value. If Apple’s stock fell below $100 (the strike price) sometime next year, I could still sell my option at a loss. At the time of purchase, $16 of the option premium was time value. While time value decreases over time, you will always have the chance to sell the option for something prior to expiration.

You should now have a basic understanding of how options work. While it’s your decision whether you want to include options in your investment portfolio, I highly recommend that you learn about investing using options.

A great resource to calculate options prices is Ivolatility’s Options Calculator.

Read part 2 of the ‘Options Investing’ series on how stock options are more profitable than buying shares.

As always, remain disciplined with your investment decisions! Good luck!