Options: The Basics

The Foolish approach to options.

After your introduction, you may be asking, so, what are these option things, an
d why would anyone consider using them?
Options represent the right (but not the obligation) to take some sort of action
by a predetermined date. That right is the buying or selling of shares of the u
nderlying stock.
There are two types of options, calls and puts. And there are two sides to every
option transaction -- the party buying the option, and the party selling (also
called writing) the option. Each side comes with its own risk/reward profile and
may be entered into for different strategic reasons. The buyer of the option is
said to have a long position, while the seller of the option (the writer) is sa
id to have a short position.
Option Trades
Call Buyer (Long Position) Call Seller (Short Position)
Put Buyer (Long Position)

Put Seller (Short Position)

Note that tradable options essentially amount to contracts between two parties.
The companies whose securities underlie the option contracts are themselves not
involved in the transactions, and cash flows between the various parties in the
market. In any option trade, the counterparty may be another investor, or perhap
s a market maker (a type of middle man offering to both buy and sell a particula
r security in the hopes of making a profit on the differing bid/ask prices).
What's a call option?
A call is the option to buy the underlying stock at a predetermined price (the s
trike price) by a predetermined date (the expiry). The buyer of a call has the r
ight to buy shares at the strike price until expiry. The seller of the call (als
o known as the call "writer") is the one with the obligation. If the call buyer
decides to buy -- an act known as exercising the option -- the call writer is ob
liged to sell his/her shares to the call buyer at the strike price.
So, say an investor bought a call option on Intel (NASDAQ: INTC) with a strike p
rice at $20, expiring in two months. That call buyer has the right to exercise t
hat option, paying $20 per share, and receiving the shares. The writer of the ca
ll would have the obligation to deliver those shares and be happy receiving $20
for them. We'll discuss the merits and motivations of each side of the trade mom
entarily.
What's a put option?
If a call is the right to buy, then perhaps unsurprisingly, a put is the option
to sell the underlying stock at a predetermined strike price until a fixed expir
y date. The put buyer has the right to sell shares at the strike price, and if h
e/she decides to sell, the put writer is obliged to buy at that price.
Investors who bought shares of Hewlett-Packard (NYSE: HPQ) at the ouster of form
er CEO Carly Fiorina are sitting on some sweet gains over the past two years. An
d while they may believe that the company will continue to do well, perhaps, in
the face of a potential economic slowdown, they're concerned about the company s
liding with the rest of the market, and so buy a put option at the $40 strike to
"protect" their gains. Buyers of the put have the right, until expiry, to sell
their shares for $40. Sellers of the put have the obligation to purchase the sha
res for $40 (which could hurt, in the event that HP were to decline in price fro
m here).
Why use options?
A call buyer seeks to make a profit when the price of the underlying shares rise
s. The call price will rise as the shares do. The call writer is making the oppo
site bet, hoping for the stock price to decline or, at the very least, rise less
than the amount received for selling the call in the first place.
The put buyer profits when the underlying stock price falls. A put increases in
value as the underlying stock decreases in value. Conversely, put writers are ho
ping for the option to expire with the stock price above the strike price, or at
least for the stock to decline an amount less than what they have been paid to
sell the put.
We'll note here that relatively few options actually expire and see shares chang
e hands. Options are, after all, tradable securities. As circumstances change, i
nvestors can lock in their profits (or losses) by buying (or selling) an opposit
e option contract to their original action.
Calls and puts, alone, or combined with each other, or even with positions in th
e underlying stock, can provide various levels of leverage or protection to a po
rtfolio.
Option users can profit in bull, bear, or flat markets.
Options can act as insurance to protect gains in a stock that looks shaky.
They can be used to generate steady income from an underlying portfolio of b
lue-chip stocks.
Or they can be employed in an attempt to double or triple your money almost
overnight.
But no matter how options are used, it's wise to always remember Robert A. Heinl
ein's acronym: TANSTAAFL (There Ain't No Such Thing As A Free Lunch). Insurance
costs money -- money that comes out of your potential profits. Steady income com
es at the cost of limiting the prospective upside of your investment. Seeking a
quick double or treble has the accompanying risk of wiping out your investment i
n its entirety.
The Foolish bottom line
Options aren't terribly difficult to understand. Calls are the right to buy, and
puts are the right to sell. For every buyer of an option, there's a correspondi
ng seller. Different option users may be employing different strategies, or perh
aps they're flat-out gambling. But you probably don't really care -- all you're
interested in is how to use them appropriately in your own portfolio.
Next up: How options are quoted, and how the mechanics behind the scenes work.
Check out more in this series on options here.
Turn your portfolio into a virtual ATM
Looking to unlock a potential long-term income stream? You should download the "
Ultimate Income Report" by Motley Fool Options Co-Advisor Jim Gillies. In it he
tells you how to turn just about any stock in your portfolio into an income-prod
ucing cash cow, even if it doesn't pay a dividend! And you'll discover how some
investors have made money on 91% of their closed options trades. Click Here to G
et Your Free Report!
Jim Gillies has no position in any stocks mentioned. The Motley Fool recommends
Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may
 not all hold the same opinions, but we all believe that considering a diverse r
ange of insights makes us better investors. The Motley Fool has a disclosure pol
icy.
1 stock that could be even bigger than Amazon
Finding stocks like Amazon early is why Motley Fool Stock Advisor has tripled th
e market's return for more than a decade. A few ambitious analysts inside Stock
Advisor just discovered what they think could be the next Amazon and recommended
this tiny stock to a select group of investors committed to growing wealth.
Click here to learn more about this disruptive stock.
*Stock Advisor first recommended Amazon on 9/6/2002. Stock Advisor returns as of
5/12/2017.
============================================================================
Options: The Basics II
To employ option strategies, you need to know how to find and understand options
pricing.
If you're going to employ option strategies as part of your portfolio, you need
to know how to find and understand options pricing.
Quotable options
The first time you pull up an options quote can be overwhelming. There's conside
rable choice when it comes to the strike price and expiry month. Consider the fo
llowing call option quotes for Apple (NASDAQ: AAPL), which sported a price of $9
1 at the time of the quotes.
Strike Price

Symbol

Last Price

Bid

Ask

Open Interest
July 2007 Expiry
$85

QAAGQ

$11.80

$11.60
$11.70

18,752
$90

QAAGR

$8.70

$8.60

$8.70

16,789
$95

QAAGS

$6.30

$6.20

$6.30

21,861
October 2007 Expiry
$85

QAAJQ

$14.30

$14.30

$14.50

881
$90
QAAJR

$11.30

$11.50

$11.70

2,237
$95

QAAJS

$9.40

$9.10

$9.30

1,579
The first thing you'll notice is the plethora of option symbols, all for just on
e company! But fear not. It's really quite easy to decipher. An option symbol co
nsists of three components:
Option symbol = base symbol + expiration month code + strike price code
The base symbol may be as many as three letters in length, and may be as simple
as being the same as the general stock ticker. So, the base symbol for Ford (NYS
E: F) is F, the base symbol for General Electric (NYSE: GE) is GE, et cetera. Ot
her companies, particularly those listed on the Nasdaq that may have tickers lon
ger than three letters, are assigned base symbols that may or may not have any r
elation to the underlying stock's familiar ticker.
The expiration month code tells us, in a single letter, when the option expires
and whether it's a call or a put. The letters "A" through "L" are assigned to ca
ll option, with "A" denoting a January expiry, "B" denoting February expiry, and
so on. Letters "M" through "X" represent put options, "M" assigned to January,
"N" to February, and so forth. Expiry takes place the third Friday of the associ
ated expiration month.
The strike price codes are a little more complicated, given that stock prices th
emselves can be all over the map. At its simplest, "A" refers to a $5 strike, "B
" a $10 strike, and so forth.
The highlighted call in the table has the symbol QAAGR, telling us that the base
symbol for Apple options is "QAA," expiration month code is "G" and signifies J
uly expiry, and the strike price code of "R" corresponds to a $90 strike price.
You'll also see three prices quoted. The "Last Price" is simply what it says it
is -- the last traded price of the option. However, this last price may have bee
n at a very different price than what the next transaction will occur at. Like a
ny security, the "bid" price is what the counterparty is willing to buy the secu
rity for, and the "ask" price is what the counterparty is willing to sell the se
curity for. With options, there can be substantially less liquidity in the marke
t. Consequently, you definitely need to watch the bid-ask spread.
Stocks with a greater option volume and greater trading generally have a narrowe
r spread. Those $90 Jul '07 Apple calls have a spread of 1.2% between bid and as
k. The stock currently has its bid and ask only one penny apart, meaning the bid
-ask spread is a minuscule 0.01%. And Apple has some pretty tight bid-ask spread
s. Options on smaller companies can have positively murderous spreads -- 6%, 8%,
or even 10% or more.
You'll note that call prices decline, while put prices rise, as the strike price
on the option increases. This is as it should be. If IBM (NYSE: IBM) trades at
$95, which call option would you anticipate as more valuable? The one letting yo
u buy shares at $90 (which you could immediately turn around and sell in the mar
ket for a $5 profit), or the one letting you buy shares at $100 (which would cos
t you $5 more than what you would pay on the open market today)? Invoking the ol
d "bird-in-the-hand" idiom, you'd happily pay more for the one that comes with t
he built-in profit. We'll get to option pricing in our next article.
Finally, know that options are sold in contracts for 100 shares. In buying that
$90 Jul '07 Apple call, you're buying the right to purchase 100 shares of Apple
for $90 before the third Friday in July 2007, and paying $870 ($8.70 * 100) for
the privilege. The last column in the table shows the "Open Interest" on that pa
rticular option -- the net number of outstanding open contracts. An opening tran
saction occurs with an initial buy or sell of an option. A closing transaction t
akes place at a later date to offset the initial buy or sell. An investor who in
itially buys a put option adds to the open interest. If the investor later sells
that put option to close out his position, it subtracts from open interest. Gen
erally, we don't worry too much about open interest, with one exception -- if yo
u're dealing in options where the open interest is only a few hundred contracts,
it signifies that low liquidity I mentioned, likely leading to a wide bid-ask s
pread.
Exercise and assignment
Exercising an option simply means that the buyer of the call or put invokes the
right to buy or sell the underlying stock at the strike price. When the option b
uyer (or holder) decides to exercise, the writer of the option is assigned an ob
ligation to fulfill the terms of the contract. The hypothetical writer of that $
90 July Apple call must deliver 100 shares, receiving $9,000 in return.
The mechanics of matching an exercising option holder with an assigned option wr
iter is handled behind the scenes by the options clearing corporation. But once
assigned, the writer must fulfill his/her end of the bargain, either delivering
shares already owned, buying shares on the open market, or shorting shares and d
elivering those in fulfillment of the contract (of course, the writer then has t
he obligation to go back at some point and cover the short).
Know, too, that exercise at expiry is generally automatic and handled by the opt
ions clearing corporation, but again recall that most option traders close out t
heir positions with offsetting contracts prior to expiry -- unless expiry happen
s to be advantageous to the trader.
European or American?
You may occasionally hear the terms "European" or "American" style options throw
n around. These terms don't refer to geography, but simply denote differences in
the stipulations attached to the options. A European option is one that can onl
ybe exercised at expiry and not before. An American option is one that can be ex
ercised at any time right up to expiry. Traded options that you'll find quoted a
re American in nature, although you'll find that early exercise of such an optio
n usually doesn't make a lot of sense (as for why, that topic's coming).
Reading option quotes is fairly straightforward, but prices often come with wide
r spreads than do much more heavily traded stocks.
Next up: You know how to get option prices. Now, what do they mean?
Check out more of our options series here.
Jim Gillies has the following options: long January 2018 $175 calls on Internati
onal Business Machines, short January 2018 $175 puts on International Business M
achines, short July 2016 $105 calls on Apple, long January 2018 $95 calls on App
le, and short January 2018 $95 puts on Apple. The Motley Fool owns shares of and
recommends Apple and Ford. The Motley Fool owns shares of General Electric Comp
any. Try any of our Foolish newsletter services free for 30 days. We Fools may n
ot all hold the same opinions, but we all believe that considering a diverse ran
ge of insights makes us better investors. The Motley Fool has a disclosure polic
y.
1 stock that could be even bigger than Amazon
Finding stocks like Amazon early is why Motley Fool Stock Advisor has tripled th
e market's return for more than a decade. A few ambitious analysts inside Stock
Advisor just discovered what they think could be the next Amazon and recommended
this tiny stock to a select group of investors committed to growing wealth.
Click here to learn more about this disruptive stock.
*Stock Advisor first recommended Amazon on 9/6/2002. Stock Advisor returns as of
5/12/2017.
How to Invest in Options
Options: The Basics
Options: The Basics II
Options Pricing: A Beginning
Options Strategies: Profits and Losses
Learn about Motley Fool Options $
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Answered! Is It Dangerous to Carry Too Many Credit Cards?
How many credit cards do you carry?
Nathan Hamilton
(TMFHamFoolery)
May 13, 2017 at 10:06PM
People carrying credit cards tend to sit in two opposing camps: those who are de
vout single-card-carriers, and those who carry a wallet packed with cards to str
etch rewards across umpteen spending categories. But what's the right number of
cards to carry, and what credit score considerations need to be taken into accou
nt?
In the previously recorded Facebook Live video below, Motley Fool analysts Natha
n Hamilton and Michael Douglass answer a user-submitted question about how many
credit cards people should carry.
Turn your portfolio into a virtual ATM
Looking to unlock a potential long-term income stream? You should download the "
Ultimate Income Report" by Motley Fool Options Co-Advisor Jim Gillies. In it he
tells you how to turn just about any stock in your portfolio into an income-prod
ucing cash cow, even if it doesn't pay a dividend! And you'll discover how some
investors have made money on 91% of their closed options trades. Click Here to G
et Your Free Report!
Michael Douglass: Donny asks, "Is there such a thing as too many credit cards, e
ven though you're able to stay below 15% utilization?"
Nathan Hamilton: It depends on how much time you're willing to give to managing
your finances. I look at it as, you can have 10 credit cards and have a really g
ood credit score, but you're going to be spending time on managing the bills. Th
at's logging into, say, a Chase account, logging into a Bank of America account,
logging into Capital One, if you carry cards across all these issuers. That tak
es time. So, it does take away from other parts of life. If you do find value in
it, if it's something that's more of a hobby, and you like having the cards, yo
u manage your budget well, you use a card for each category -- one for gas, one
for groceries, one for other purchases to stretch your rewards -- sure. It makes
sense. But I ultimately just say, how much time do you want to devote to managi
ng your finances for your credit cards? You have to look at the downsides of it.
On average, people with credit cards spend about 18% more than they would on de
bit. The likelihood of having many credit cards is, you're introducing complexit
y to your personal finances, and there's a higher likelihood of getting into deb
t. So, you have to balance it all out and look at it. But ultimately, if this qu
estion is more credit score related, not a huge amount, assuming you're paying o
n time, your utilization is low, there's not a ton of inquiries, and so forth.
Douglass: Yeah. I will say, as I mentioned earlier, we love this kind of stuff.
We're here at The Motley Fool because this is the sort of hobby we would be doin
g in our spare time regardless. So, it's kind of cool that we get paid to do ins
tead.
Hamilton: Exactly.
Douglass: Amen to that. But, the idea of managing more than two or three credit
cards, to me, sounds totally exhausting. I only have one right now, and I'm plan
ning to open another one at some point, but the idea of, OK, I'm at the gas stat
ion, that's this one. I'm at the grocery store, that's this one. I'm getting Tha
i takeout, that's this other one -- for me, that would be too much, even for me,
even though I love this stuff.
Hamilton: Yeah, same here.
Nathan Hamilton owns shares of Facebook. The Motley Fool owns shares of and reco
mmends Facebook. The Motley Fool has a disclosure policy.
1 stock that could be even bigger than Amazon
Finding stocks like Amazon early is why Motley Fool Stock Advisor has tripled th
e market's return for more than a decade. A few ambitious analysts inside Stock
Advisor just discovered what they think could be the next Amazon and recommended
this tiny stock to a select group of investors committed to growing wealth.
Click here to learn more about this disruptive stock.
*Stock Advisor first recommended Amazon on 9/6/2002. Stock Advisor returns as of
5/12/2017.
Author
Nathan Hamilton
Nathan Hamilton
(TMFHamFoolery)
A Fool since 2014, Nathan bridges the gap between saving and investing, covering
topics from credit cards, mortgages, and credit scores to consumer and technolo
gy stocks. Twitter
Article Info
May 13, 2017 at 10:06PM
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Is This Synaptics Next Big Opportunity?
Synaptics' recent earnings report revealed a big long-term catalyst.
Harsh Chauhan
(TechJunk13)
May 13, 2017 at 8:53PM
Shares of Synaptics (NASDAQ:SYNA) got a much-needed shot in the arm after the co
mpany's third-quarter fiscal 2017 results easily bested Wall Street's expectatio
ns. The human interface solutions provider's revenue jumped 10% year-over-year (
to $444.2 million), translating into $1.27 per share in earnings. By comparison,
analysts were expecting $1.20 per share in earnings on $430 million in revenue.
Synaptics' results were warmly received, and the stock shot up 6% during the pos
t-earnings action, bringing relief to investors amid speculation that the compan
y could lose business from Apple (NASDAQ:AAPL). More importantly, CEO Richard Be
rgman provided clarity about the company's next big growth driver -- edge-to-edg
e smartphone displays -- where Synaptics is trying to lead the field with its pr
oduct development moves.
A Synaptics display driver.
Image Source: Synaptics
Why edge-to-edge displays could be a big deal for Synaptics
The display of Samsung's latest flagship smartphone, the Galaxy S8, covers the f
ront of the device almost entirely. This has led to the elimination of the home
button, which traditionally houses the fingerprint sensor to unlock the device.
Samsung had been collaborating with Synaptics to integrate the fingerprint scann
ing technology into the display, but it wasn't ready in time for deployment into
the Galaxy S8. Instead, Samsung had to place Synaptics' fingerprint sensor at t
he back of the device, near the camera, just before the device went into product
ion.
Industry sources are reportedly blaming Synaptics' delayed development for Samsu
ng's last-minute change. But it's really no surprise it wasn't ready.
The semiconductor specialist currently has the "only workable solution" to integ
rate the fingerprint scanner into the touchscreen, per Cowen analyst Timothy Arc
uri. And Synaptics' FS9100 optical fingerprint sensor -- which can scan fingerpr
ints through 1mm of glass -- was only launched in December 2016. Synaptics start
ed sampling it to customers in the first quarter this year and the company had i
ndicated that mass production would begin only in the second quarter. So people
shouldn't have expected the sensor to be in the Galaxy S8.
However, Cowen forecasts that Samsung's next Note device will be the first one t
o sport the touch and display integration (TDDI) while Korean news publication T
he Bell's unnamed sources confirm the same. Samsung is expected to launch the ne
xt Note in the second half of the year, giving Synaptics enough time to ramp up
production of the integrated sensor.
Synaptics' product lead in this market and its Samsung partnership will play a c
rucial role in capturing a bigger share of the TDDI space. IHS Markit forecasts
that TDDI chip demand will jump to 654 million units in 2022 compared to this ye
ar's projected shipments of 100 million units. Synaptics is one of just three co
mpanies in this space, and is the only one to have licensed its intellectual pro
perty to display panel makers.
Will Apple use Synaptics' solutions?
Leaked specs of what purports to be the next iPhone's case molding (via Slash Le
aks) indicates that Apple won't go the Samsung route by placing the Touch ID on
the back of the device. Instead, it could integrate the device into the rumored
OLED display and remove the iconic home button in the process.
But an Apple move toward TDDI doesn't guarantee Synaptics a slot inside the devi
ce, as Cupertino has been reportedly developing an in-house display and fingerpr
int sensor integration technology. Motley Fool contributor Ashraf Eassa believes
it highly unlikey that the iPhone maker bought AuthenTec to build Touch IDs in-
house for just a few iPhone models.
This makes sense, and indicates that Apple could be developing its own system. H
owever, Synaptics can still hope for a spot if Apple's product development falls
behind schedule. But investors shouldn't worry too much even if the chipmaker d
oesn't land a spot in the next iPhone thanks to the end market's secular growth.
As mentioned earlier, sales of TDDI chips are estimated to boom in the long run,
and Synaptics is probably the best-positioned company to take advantage of the
opportunity. This is because Apple is unlikely to license its technology to othe
r smartphone companies, using it exclusively for its iPhones. Japan Display, the
other operator in this space, is primarily a flat-panel display provider, so it
might find it difficult to license its technology to rival display makers.
Synaptics, therefore, is sitting on a huge opportunity that could give its reven
ue a nice boost in the long run.
5 Simple Tips to Skyrocket Your Credit Score Over 800!
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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool owns shar
es of and recommends Apple. The Motley Fool has a disclosure policy.
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Options Pricing: A Beginning
Which options should you buy? What strike price? What expiration date?
Let's say that a stock's shares sell for $30. You like the company. You like the
price. In fact, you really like the price. So much so, that in addition to buyi
ng shares outright, you decide to augment your potential gains by buying some ca
ll options. If you're right, the price of the shares will rise and take the valu
e of the options with it. But which options should you buy? What strike price? W
hat expiration date? How will the option price behave as the stock price rises?
What if the stock price falls? What happens as we approach the expiration date?
Two component pricing
An option price is the sum of two components: intrinsic value (IV) and time valu
e (TV),
Option value = IV + TV
IV is the difference between the stock price and the option's strike price. Howe
ver, IV cannot be less than zero, since the optionholder wouldn't exercise a cal
l with a strike price of $30 if the same stock is trading in the market at $25.
(If you know someone who would do such a thing, please email me their contact in
formation.) IV is calculated based on how the underlying stock price moves in re
lation to the option strike price:

Stock Price < Strike Price

Stock Price > Strike Price

Stock Price = Strike Price

Call

$0

Stock Price-Strike

$0
Put

Strike Price-Stock Price

$0
$0
TV is simply the premium that people are willing to pay for the potential upside
of the stock until expiry. Options can be termed "wasting assets." Over time, a
s expiration draws near, TV will get smaller and smaller until there's finally n
o remaining time and TV = 0. Thus, at expiry, the value of the option is simply
IV. Prior to expiry, TV is always positive even though it may be very, very smal
l.
Back to reality
Consider the following fictional call options on our fictional company.
Option Number

Strike Price

Symbol

Ask Price

Expiry

IV

TV
1

$27.50

[five letters]

$3.60

May-07

$2.50

$1.10
2

$27.50
[five letters]

$4.30

Jul-07

$2.50

$1.80
3

$27.50
[five letters]
$5.10

Oct-07

$2.50

$2.60
4

$30

[five letters]

$1.95

May-07

$0

$1.95
5

$30

[five letters]
$2.75

Jul-07

$0

$2.75
6

$32.50
[five letters]
$1.60

Jul-07

$0

$1.60
There are three key observations from this table:
1) Anytime the strike price is greater than or equal to the current stock price,
IV is zero. In such cases, the option value is solely attributable to TV, and t
he expectation (hope?) that the price will get itself up above the strike price
by expiration.
2) The less time remaining until expiry, the lower the TV. (Presumably, this is
intuitive.) Note the three options all having $27.50 strike prices, and hence id
entical IVs. Then note that the May option has only $1.10 of TV, while the Octob
er call has $2.60 of TV. More time imparts greater value.
3) For options with a common expiry date, TV is maximized when the strike price
and the stock price are equal. As the stock price moves in either direction, TV
falls.
These latter two points are illustrated in the following chart. Observe that TV
is maximized at the strike price and that the options with less time remaining a
re seeing their TV decay, and their curves falling to the blue IV line.
Price Curves for Different Expires
Money-ness
You'll hear phrases like "in-the-money" or "out-of-the-money" bandied about. Thi
s is just a fancy way of denoting whether an option has intrinsic value or not.
If IV is positive, the option is said to be in-the-money. If IV is zero, it's te
rmed out-of-the-money (pretty complicated, no?)
Expressing options as the sum of IV and TV also leads to the conclusion that ear
ly exercise of options generally doesn't make sense (though there are, as always
, exceptions to the rule). The thinking goes like this:
1) An option is worth IV + TV.
2) I can exercise it now and receive IV, or
3) I can sell the option and receive IV + TV.
4) IV + TV is more than IV. Therefore, selling an option rather than exercising
early is the superior choice.
There is always the potential for option holders to act irrationally and exercis
e even though they give up TV that they could have harvested by selling the opti
on. Fortunately, such cases are rare. There is, however, a situation where early
exercise may become an issue.
Options on dividend-paying stocks
If a company pays a dividend, particularly a hefty one-time dividend, it can pro
voke early exercise. In theory, a stock's price falls on the ex-dividend date by
the amount of the dividend. Option holders don't receive the dividend, though,
so they might sell the option before the ex-dividend date to avoid the price dro
p.
If, however, the dividend is greater than the remaining TV of an option, then ea
rly exercise can make sense.
Consider a stock selling for $41 that is going to pay a $1 dividend, going ex-di
vidend tomorrow. A call option on the stock has a $30 strike price, sells for $1
1.50, and expires a week later. This option has an IV of $11 and $0.50 of TV. As
suming that the stock price falls by the amount of the dividend as anticipated (
and for ease of calculation, we'll assume the stock price stays flat to expiry),
the option holder is better served by exercising early.
Early exercise means that the option holder pays $30 for shares currently worth
$41. He then receives a dividend of $1 and continues to hold shares worth $40. C
onversely, holding the option through the ex-dividend date until expiry sees the
remaining TV dissipate, and the holder ends up with just the shares worth $40.
Next up: Option pricing seems awfully tied to outside influences. Is there a qui
ck way to see how much I can profit or lose?
Check out more of our options series here.
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l hold the same opinions, but we all believe that considering a diverse range of
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Options Strategies: Profits and Losses
Is there a quick way to see how much I can profit or lose?
Which strategy is best for you?
A quick recap. So far, we've introduced the two types of options -- calls and pu
ts. We've highlighted that there are two sides to a transaction -- the buyer and
seller. We've discussed how to get option quotes, what those quoted prices mean
, and a little about how they change with various external factors. Now, let's t
ry to tie these concepts together graphically, laying out the profit and losses
from four basic option strategies. We'll use the following options on Dell (Nasd
aq: DELL), whose shares are trading at $22.50, to illustrate:
Option

Call

Put
Symbol

DLQHX

DLQTX
Strike Price

$22.50

$22.50
Expiry

Aug-07

Aug-07
Option Price

$1.85

$1.35
Basic strategy 1: The long (buy) call
Buying a call gives us the right to buy Dell for $22.50 until the third week of
August 2007. We would pay $185 per contract (remember that options are sold in c
ontracts of 100) for that right. How much can we make, and how much can we lose?
The loss part is easy. No matter how far Dell falls between today and expiry, ou
r risk of loss is capped at the $185 per contract we're investing. If the market
gets crushed, there's blood in the streets, dogs and cats are marrying each oth
er, and Dell goes to $14 -- no problem. A bad situation, perhaps, for those who
simply bought Dell shares outright and are now sitting on an $850 loss, but reas
onably comfortable for our call buyer. On the other hand, there's (theoretically
) no limit to how high Dell could go before expiry. And any rise in Dell's stock
price will be matched, dollar for dollar, with a rise in the price of the call.
We can represent our profits and losses in both a tabular format and graphically
with a simple two-axis plot. Profit equals the intrinsic value of the option le
ss the cost to initially purchase the option. The horizontal axis shows the stoc
k price at expiry, while the vertical axis shows the profit/loss potential. The
shaded blue area above the horizontal axis is where the option is profitable, wh
ile the shaded blue area below the horizontal axis shows when the option buyer f
aces a loss.
Long Call
Stock Price At Expiry

Profit/(Loss) At Expiry
$15

($1.85)
$20

($1.85)
$22.50

($1.85)
$24

($0.35)
$25

$0.65
$30

$5.65
Note that, though the option has a strike price of $22.50, the option buyer does
n't actually make a profit until the stock goes above $24.35 (the cost of the op
tion plus the strike price). Also note that if the option expires when the stock
price is between the break-even price and the strike price, the option buyer is
still better off exercising, since some of the loss taken on the initial call b
uy can be recouped.
Basic strategy 2: The long (buy) put
We can similarly show a risk profile for any option position. Perhaps we're bear
ish on Dell's prospects and are seeking to profit by buying a put option. In suc
h a case, our maximum loss is $135, while our maximum profit would occur if Dell
went bankrupt before our option expiry (don't hold your breath).
Long Put
Stock Price At Expiry

Profit/(Loss) At Expiry
$15

$6.15
$20

$1.15
$21.50

($0.35)
$22.50

($1.35)
$25

($1.35)
$30

($1.35)
Basic strategy 3: The short (sell) call
What about the other side of the trade? Somebody is always selling the options t
hat the counterparties are buying. The profit payouts of the option writers are
the mirror opposites to those of the option buyers. So where a call buyer has a
capped downside risk and unlimited upside, the call writer has a capped profit p
otential and an unlimited downside risk (hmm ... that doesn't sound like much fu
n).
Short Call
Stock Price At Expiry

Profit/(Loss) At Expiry
$15

$1.85
$20

$1.85
$22.50

$1.85
$24

$0.35
$25

($0.65)
$30

($5.65)
Those who go short calls are generally down on the stock's prospects, at least u
ntil expiration. In isolation, those who go short calls are playing with fire wi
th that potential unlimited downside.
Basic strategy 4: short (sell) put
Finally, the short put mirrors the profit and loss profile of the long put and i
s generally employed by those who are bullish on the underlying stock. The maxim
um potential profit is equal to the money received upfront from the put sale, wh
ile the maximum loss occurs if the stock goes to zero. Someone who believes that
Dell will do just fine in the near term may sell puts to gain extra income.
Short Put
Stock Price At Expiry

Profit/(Loss) At Expiry
$15

($6.15)
$20

($1.15)
$21.50

$0.35
$22.50
$1.35
$25

$1.35
$30

$1.35

Check out more of our options series here.

Try any of our Foolish newsletter services free for 30 days. We Fools may not al
l hold the same opinions, but we all believe that considering a diverse range of
insights makes us better investors. The Motley Fool has a disclosure policy.
1 stock that could be even bigger than Amazon
Finding stocks like Amazon early is why Motley Fool Stock Advisor has tripled th
e market's return for more than a decade. A few ambitious analysts inside Stock
Advisor just discovered what they think could be the next Amazon and recommended
this tiny stock to a select group of investors committed to growing wealth.
Click here to learn more about this disruptive stock.
*Stock Advisor first recommended Amazon on 9/6/2002. Stock Advisor returns as of
5/12/2017.
================================================================================
==============
An Easy Strategy to Ease Into Options
Spreads let you capture gain while controlling your risk.
Just when you thought the market was safe again, a day like Monday serves as a s
tark reminder that despite the huge losses of the past year and a half, stocks c
an still fall further. In response, many people have scurried for cover, looking
for investing strategies that will allow them to reduce their risk.
Few of these investors will look to options strategies for solutions to their ri
sk management concerns. Yet while many investors use options to magnify risk rat
her than controlling it, a variety of options strategies exist that can actually
reduce your exposure to the market -- while still allowing you to reap some of
its benefits.
The lose-everything trap
Options strategies get complicated in a hurry, and with good reason: for every s
tock, there are dozens of different options available, and an even greater numbe
r of combinations of options you can put together to achieve a particular goal.
By choosing one option over another, you can be bullish or bearish, risk a small
amount or a huge one, and control the likelihood of making a profit.
The biggest concern in using options is how easy it is to lose your entire inves
tment. For instance, if you're bullish on a stock but want to limit your downsid
e, buying a call option gives you the best of both worlds: profits if the stock
rises, but limited loss if the stock falls. The problem, though, is that you can
easily lose your entire investment in an option if things don't go your way.
Spread out your risk
That's where spreads come in. Spreads involve using two options: buying one and
selling one. For a bull spread, you buy a call option with a given strike price
and sell another call option with a higher strike.
Compared to just buying the call option outright, a bull spread limits your upsi
de, but the overall position is often much cheaper. Consider an example:
Wal-Mart(NYSE: WMT) shares closed Monday at $49.27. A simple bullish options str
ategy would be to buy a call option. A May 50 call would cost you $1.44 per shar
e, letting you share in all the upside if shares rise above $50 by this time nex
t month. But if Wal-Mart stays where it is, then you'll lose the entire $1.44.
In contrast, a bull spread might involve buying the May 50 call but selling the
May 52.5 call for $0.60. You no longer have unlimited gain potential -- even if
shares soar well above $52.50, the most you'll gross from the strategy is $2.50,
leaving you a net profit of $1.66. But you also cut your maximum loss almost in
half, from $1.44 to $0.84.
Limiting risk
Bull spreads let you bet on rising shares, while the similar bear-spread strateg
y involves put options and pays profits when shares fall. Depending on exactly w
hich options you use, you can change your risk profile substantially. Here are a
few more examples:
Stock

Share Price

Buy Option

Sell Option

Net Cost
Oracle (NASDAQ:ORCL)

18.82

December 19 call (2.30)

December 23 call (0.95)

1.35
Merck (NYSE: MRK)

25.22
July 25 call (2.15)

July 27.5 call (1.05)

1.10
SPDR Financial (NYSE:XLF)

9.87

June 10 put (1.32)

June 8 put (0.51)

0.81
Sears Holdings (NASDAQ: SHLD)

59.32

June 60 put (8.70)

June 50 put (3.80)

4.90
Goldman Sachs (NYSE: GS)

115.01

Oct 100 call (27.40)

Oct 120 call (16.45)

10.95
Microsoft (NASDAQ: MSFT)

18.61

Oct 24 call (0.55)

Oct 25 call (0.39)

0.16
Source: CBOE. Prices as of market close on April 20.
As you can see, you can tailor your strategy in any number of ways. You can go a
fter a small gain with an even smaller risk of loss, or you can look to reap big
rewards but potentially lose a lot more.
Not for the meek
Of course, even spreads involve plenty of risk. If the stock moves against you,
you'll still lose the full net amount you paid for the position. But the spread
strategy offsets your losses somewhat from what you'd lose just by buying a sing
le option.
Many investors find options too cumbersome and difficult to analyze. But if you
want to tailor your portfolio exposure to exact specifications, you can't find a
better tool than options. And for beginning options investors, spreads are a gr
eat way to get to see how the options market works without taking on the full ri
sk of a more aggressive strategy.
For more on options, read about:
How to get protection for your stocks.
Insure yourself against huge losses.
5 stocks for strong income.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool owns shar
es of Microsoft. Try any of our Foolish newsletter services free for 30 days. We
Fools may not all hold the same opinions, but we all believe that considering a
diverse range of insights makes us better investors. The Motley Fool has a disc
losure policy.
1 stock that could be even bigger than Amazon
Finding stocks like Amazon early is why Motley Fool Stock Advisor has tripled th
e market's return for more than a decade. A few ambitious analysts inside Stock
Advisor just discovered what they think could be the next Amazon and recommended
this tiny stock to a select group of investors committed to growing wealth.
Click here to learn more about this disruptive stock.
*Stock Advisor first recommended Amazon on 9/6/2002. Stock Advisor returns as of
5/12/2017.