What is an Option? (Call)
Stock Options are complicated financial instruments that need to be handled accordingly. Always remember “not preparing to win is preparing to lose.” You must study and understand all the subject matter. We are going to start with a definition of “Stock Option” according to Investopedia.com, an online dictionary for words and terms having to do with the stock market.
Stock Option: A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.
Well, if you’re a beginner, you can see the strange lingo is already kicking in. Let me try to explain in terms we speak on “Main Street.” There are two types of options: a Call Option and a Put Option. We are going to move the Put Option onto the back burner for a while until we completely learn what a Call Option is first. The Put Option will be covered on the page which is called “What is an Option? (Put).”
My real life “Real Estate Option”
To explain what an option is, I like to use real estate as an example. I feel real estate is a much easier example to understand because more people can relate to, or have done, real estate deals themselves. Also, the stock market and especially stock options has terminology or “strange lingo” that exacerbates the confusion of an already complicated subject. Whether we are talking about stock options or real estate options, in many ways they are similar. You can buy or sell a stock option; you can also buy or sell a real estate option. The big difference is, when you buy or sell a real estate option, everyday language will be used, if not, you usually have a lawyer involved to help. With a stock option, it will be in “Wall Street” jargon with strange terms. There’s no need to get worried! We will learn every word of this lingo as we go along.
This real estate option example I’m about to explain is a true, real-life example. I negotiated and executed this deal with the first piece of real estate I ever bought. This deal happened in the mid-1980s and it involved a house I had already lived in, in NYC, as a rental. It was a house that needed a lot of work, but I rented it because it was in an area I want to live. I rented from a woman named Mary who owned it as an investment. I rented as a family man with one child, and one on the way. My rent was $400 a month. After living there for a year, and doing many minor repairs I wanted to do much more. I decided to ask Mary if she would be interested in selling me the house. I explained to her that I would like to make the house more comfortable for my family, but there was too much work to be done, and money to be spent as a renter. She explained, she didn’t want to sell the house for three years until she was 50 years old. At that time the IRS had a “tax benefit” in their code which stated anyone can sell a house, once in their life, tax free, if they were over the age of 50. Mary said she would sell, but I would have to wait 3 years because she wanted to take advantage of this IRS tax benefit. I was in a bit of a dilemma. I wanted to do major work, like replacing the roof, refinishing floors, replacing windows and doors, installing a fence, putting in a pool, landscaping — all very costly work. Work I would only do if I owned or was going to own. I put my thinking cap on to figure a way I would feel comfortable making an investment in this house knowing I would eventually be the owner. The thinking I did is the type of thinking you need to do when trading options to insure a desirable conclusion to a deal. I set up a meeting with Mary to present the deal I came up with. I told her I would like to buy the house. I said, “I would like to have a contract with the option to buy her house three years into the future.” I would like to have a price in the contract and if she agreed to this, I would be willing to pay her for that option. I also said I would be paying rent while I waited to buy, so I would like to get some rent credit which would go toward the price of the house. The house was appraised for $45,000 (remember this was the 1980s). Her concern was with the sale price of the house. “I don’t know what the price of the house will be three years from now”, she said. I added a price into the deal I felt she would be comfortable with. The deal went as follows: I will pay $60,000 for the house on a specific date three years in the future. I would get a $200 rent credit per month to go toward the price of the house. For this contract, I would agree to pay a non-refundable $5,000 fee at contract signing. She agreed and I got the contract. This contract gave me the right to buy the house in three years, but not the obligation to buy. With this contract, Mary had the obligation to sell. She could not get out of the deal unless I approved. She was betting the value of the house would not go above the price $65,000: the price of the house plus the non-refundable $5,000 I gave her. I was betting the value of the house was going to be above the $65,000 minus the rent credit which would be $7,200 for the 36 months at $200 a month.
When developing real estate deals, you can get creative like adding the rent credit portion of my deal. With stock option deals, there are no “rent credit” type of deals. I added this to my story because it was part of my contract, and I wanted to explain exactly how my deal went. Believe me, although there are no rent credits with stock options, there are many ways to get creative which you will learn later or in the future with your never ending education and your own creative ability. Because we are learning about stock options, I will drop the rent credit part of my real estate story and examine the option portion to focus on the similarities with a stock option.
The house was appraised at $45,000. I paid Mary $5,000 for the option to buy her house, three years in the future for $60,000. I had the right to buy her house in 3 years and she had the obligation to sell her house, if I wanted to buy.
Before we get into stock options, lets see how my real estate deal played out. Mary and I signed our contract in 1983. In and around NYC, real estate really started to jump around 1984-85. I was watching the value of real estate very closely as I’m sure Mary was too. By the end of 1984, similar properties were selling in the area for $100,000. As a young man, with a new family, I was very excited. I don’t think I could say the same for Mary, she was not so happy! Remember, Mary had the obligation to sell this property for $60,000. A little more time had passed and there was no sign of real estate slowing down. A little into 1985, Mary approached me to ask if I would be willing to let her out of her contract. She offered me $20,000. It was then I realized that options have value. I declined her offer, and she upped it to $25,000. I also declined her new offer, but I must say, it was getting interesting. The way I looked at it, if I had a contract to buy the house for $60,000 and its worth $100,000, she would have to make an offer of at least $40,000 plus there was still a little over a year left for my contract to expire. I felt the value of this property could continue to rise substantially. The value between the $60,000 and the current value which was $100,000 is called the “intrinsic value.” The intrinsic value was $40,000! There is also value in the time that is left to the contract because the property could continue to rise for another year. Because there is plenty of time remaining to the contract for the property value to move up substantially, you must put value on the remaining time. This is called “time value.” I was not willing to exit this contract unless I received compensation for the “intrinsic value” plus compensation for time remaining to the contract which is the “time value.” My offer to Mary was $40,000 for the intrinsic value, plus I put another $20,000 for the time value. This would be a total of $60,000 to exit the contract. If there was only a month or two remaining to to the contract, the time value would not be so great. I cannot stress enough, intrinsic value and time value are major parts of the value of an option, whether a real estate option or a stock option. You must understand the meaning of these two terms. They are a part of the Wall Street lingo and you will use them your entire option trading career. (See “Intrinsic Value & Time Value” in the Education section.)
Mary declined my contract buy-out offer, so it stayed in force until expiration. One month before the contract expired, I notified Mary, in writing, that according to our contract, I would be purchasing her property. Everything went smooth! When I had the house appraised, the appraisal came in at $165,000. As a young man in my 20’s, starting out, I cannot emphasize enough what this real estate option deal did for my future. At closing, I instantly had well over $100,000 in equity. My father used to say, “A man’s wealth is not measured by the amount of money he has; it’s measured by the amount of money he can borrow.”
Now I am a man in my 60s. I have made countless investments in my life and it’s quite possible I would not be where I am today if not for my initial real estate option contract. The positive impact this deal had on my family is clear today. Where I go with my investment life is unclear, but I do know without this deal, my future would not be as bright.
Now that we know how my real estate option worked, we see it has great value. We are now going to examine Stock Options. Once we cover Call Options, we will review the real estate option and compare the similarities using Wall Street lingo.
What is a (Stock) “Call Option”?
In the first line of this page, I said, “Stock Options are complicated financial instruments.” Mainly, I was referring to the pricing of options; the components and calculations that go into giving options their value. The pricing of options are very complicated! At this point, we don’t have to worry about the many factors that go into the pricing of options. Options are “derivatives” investments because their value is derived from other sources, some of which are the price of the underlying stock, intrinsic value, time value and a few other sources. You will learn more about pricing as you become a more experienced trader. The only thing we need to worry about now is that options have value, and that value in called the “Premium.”
You might have heard about options in terms of high risk and high loss. They are often seen as speculative “bets” that only the high rolling risk takers want to use. This is not the case! Millions of people living on Main Street are trading options every day and a large number of option strategies are actually low-risk and worth considering even in the most conservative portfolio. I feel owning stock is more risky than some conservative options strategies.
There are two types of options. One is called a “Call” and the other is called a “Put.” In this section we are dedicated to learning what a Call option is and how it works. You can buy a Call or you can sell a Call.
If you buy a Call option, you have the right, not the obligation, to buy the underlying stock. When buying a Call, there are a few items in the contract. 1) The Underlying Stock 2) Amount of Shares of Stock 3) Strike Price 4) Expiration Date 5) Premium.
The word Contract has 2 meanings. It is used to describe a deal between two parties and it’s used to describe the amount of shares involved in an option. See #2 below.
- The Underlying Stock – Is the stock involved in the options contract. If you are looking to buy an option in International Business Machines the underlying stock is IBM. All option contracts use the underlying stock’s ticker symbol. The option order will have IBM in it describing the stock involved in the option’s contract.
- Amount of shares – The word “contract” is also used to describe the Amount of Shares involved in the option. Each “contract” is 100 shares of stock. If the buyer wants a Call Option to buy 100 shares of IBM, he buys 1 contract. If he wants an option to buy 1000 shares of IBM, he buys 10 contracts. 2000 shares, 20 contracts, etc.
- Strike Price – The price the buyer is willing to pay for a share of the stock. If he buys 10 contracts to buy IBM at $130, he has the right to buy 1000 shares of IBM and is willing to pay $130 per share (the Strike Price).
- Expiration Date – The date the option contract expires. Entering a contract on Nov 1and the Expiration Date is Nov 30, and the option’s contract says he is buying 10 contracts to buy IBM at $130. The option buyer has the right to buy the seller’s 1000 shares of IBM on or before Nov 30.
5. Premium – The amount of money the option buyer is willing to pay the option seller for the option to buy his stock. OR, the amount of money the seller receives from the option buyer, giving him the right to buy his stock. The option seller has the obligation to sell his stock if the option buyer wants to buy the shares specified in the option’s contract. If the Premium is $2. The buyer is will to pay $2 per share to buy the option contract. Here is an example of the option contract described in 1 thru 5. The buyer has the right to buy 1000 shares (10 contracts) of IBM for $130 per share, on or before Nov 30. The buyer pays the seller a Premium of $2 for this option. The seller receives $2000 in total Premium ($2 per share X 1000 shares).
What will determine if the option buyer buys the stock?
Remember, the buyer of the option has the right to buy the shares of IBM. The seller has the obligation to sell his shares of IBM, if the option buyer wants to buy them. If the price of IBM is above $130 per share on Nov 30, the buyer of the option will buy the 1000 shares of stock. If the price of IBM is below $130 per share, the option buyer will not buy the shares. He has the right to if he wants but he will not because he can buy shares of IBM cheaper on the open market. On Nov 30, if the price of IBM is $145 per share, the buyer of the option will buy the stock from the option seller for $130. That is the privilege he has because he bought the option. If, on Nov 30 the price of IBM is $115 per share, he will not buy the shares from the option seller at $130 because he can buy the shares on the open market for $115 per share. Whether the option buyer buys the shares of IBM or not, the option seller keeps the $2000 Premium.
Comparing my real estate option with the above option for IBM
- The Underlying Stock – In my real estate option the underlying stock is the house. In the stock option, the underlying stock is IBM.
- Amount of shares – In my real estate option the Amount of Shares is 1 house. In the stock option, the amount of shares is 10 contracts or 1000 shares.
- Strike Price – In my real estate option the Strike Price is $60,000. This is the price Mary agreed to sell me the house for. She had the obligation to sell me her house if I wanted to buy. In the stock option, the Strike Price is $130 per share. The seller of the option had the obligation to sell 1000 shares of IBM.
- Expiration Date – In my real estate option I could buy Mary’s house 3 years in the future. If I didn’t buy at that time the contract would have expired. In the stock option, the Expiration Date was Nov 30. The option buyer had until Nov 30 to buy the 1000 shares of IBM. After Nov 30 the contract would expire.
- Premium – In my real estate option I paid Mary $5000 to have the right to buy her house for $60,000 in 3 years. In the stock option, the buyer paid the seller $2 per share or $2000 to have the right to buy his 1000 shares of IBM, on or before Nov 30. The payment I paid Mary and the payment the buyer of the IBM option paid, is called the Premium.
I hope my real estate option deal, the stock option example and the comparison of the two, helps explain what a Call Option is. If not, continue reading “Main Street beats Wall Street”, because of my repetitive teaching, I’m sure all the pieces of the puzzle will come together.