Part 4: How Options Work

We are going to learn how Options work by reading information 

created by Investopedia Staff.

Now that you know the basics of options, here is an example of 

how they work. We'll use a fictional firm called Cory's Tequila 

Company. Let's say that on May 1, the stock price of Cory's 

Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 

Call, which indicates that the expiration is the third Friday of July 

and the strike price is $70. The total price of the contract 

is $3.15 x 100 = $315. In reality, you'd also have to take 

commissions into account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares;

that's why you must multiply the contract by 100 to get the total 

price. The strike price of $70 means that the stock price must rise

above $70 before the call option is worth anything; furthermore,

because the contract is $3.15 per share, the break-even price would 

be $73.15.

When the stock price is $67, it's less than the $70 strike price, so

the option is worthless. But don't forget that you've paid $315 for 

the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has

increased along with the stock price and is now worth $8.25 x 100

 = $825. Subtract what you paid for the contract, and your profit is 

($8.25 - $3.15) x 100 = $510. You almost doubled our money in

 just three weeks! You could sell your options, which is 

called "closing your position," and take your profits - unless, of

 course, you think the stock price will continue to rise. For the sake

 of this example, let's say we let it ride.

By the expiration date, the price drops to $62. Because this is less

than our $70 strike price and there is no time left, the option

contract is worthless. We are now down to the original investment

of $315.

To recap, here is what happened to our option investment:

	Date	1-May	21-May	Expiry Date
	Stock Price	$67	$78	$62
	Option Price	$3.15	$8.25	worthless
	Contract Value	$315	$825	$0
	Paper Gain/Loss	$0	$510	($315)

would have given us over double our original investment. This is

leverage in action. The price swing for the length of this contract

from high to low was $825, which 

would have given us over double our original investment. 

This is leverage in action.




Exercising Versus Trading-Out

So far we've talked about options as the right to buy or sell 

(exercise) the underlying. This is true, but in reality, a 

majority of options are not actually exercised.

 In our example, you could make money by exercising at $70 

and then selling the stock In our example, you could make money 

by  back in the market at $78 for a profit of $8 a share. You could

also keep the stock, knowing you were able to buy it at a discount 

to the present value.

However, the majority of the time holders choose to take their

profits by trading out (closing out) their position. This means that 

holders sell their options in the market, and writers buy their

positions back to close. According to the CBOE, about 10% 

of options are exercised, 60% are traded out, and 30% expire

worthless.

Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of 

options. In our example the premium (price) of the option went 

from $3.15 to $8.25. These fluctuations can be explained by

intrinsic value and time value.

Basically, an option's premium is its intrinsic value + time value.

Remember, intrinsic value is the amount in-the-money, which,

for a call option, means that the price of the stock equals the strike

price. Time value represents the possibility of the option

increasing in value. So, the price of the option in our example can

be thought of as the following:

$8.25 =	$8	+	$0.25

In real life options almost always trade above intrinsic value. 

If you are wondering, we just picked the numbers for this 

example out of the air to demonstrate how options work.

Here are some questions:

1. This XYZ Option contract sells for  $3.15 meaning that the speculator controls 100 shares of XYZ stock totaling $315.  
(True or False)

2.  intrinsic value is the amount in-the-money, which, 
for a call option, means that the price of the stock equals
the strike price. (True or False)

According to the CBOE, about 3._____ 

of options are exercised, 4._______are traded out, and 
5.______expire worthless.

Look up your answers.

If you got none wrong, you may have a future in Options.
If you have 1 wrong, review this blog on Options.
If you have 2 or more wrong, use an Options broker to work 
your trades.