WHEN MOST PEOPLE HEAR the phrase "stock options," they usually think of employee stock options, which many believed were their ticket to easy money and early retirement in the late 1990s. Then reality set in, rendering many of those options (at least those dished-out at dot-coms and other technology start-ups) worthless. For those folks who didn't exercise in time, that's spelled many more years in the office.
But these are only one kind of stock option — and a relatively minor one at that. While employee stock options are private contracts negotiated between companies and their employees, there's an entire class of stock options that trade on public exchanges just like stocks.
This year, more than 500 million options contracts will change hands at places like the Chicago Board Options Exchange, the American Stock Exchange and the International Securities Exchange.
And since each option contract is worth at least 100 shares of an underlying stock or index, you get a sense of the staggering size of the U.S. market.
The trouble is, options are expensive, complicated and risky. They've gotten a bad name because individual investors too often wade into these markets without enough experience and get completely took. The CBOE — the world's largest options marketplace — has been teaching individual investors the nuances of options trading for years via an educational effort called the Options Institute. In most cases, its students are far from investing novices. "Our research shows that the average investor will spend somewhere between eight and 10 years trading equities before they become comfortable enough to step out into equity options," says Terry Haggerty, a senior staff instructor.
Under certain circumstances, however, options can be beneficial. And our intent here is just to get you familiar with how these financial instruments work. So, let's go over the basics.
Options, Not Futures
First of all, some people confuse options contracts with futures contracts, since they're both derived from underlying commodities, currencies or financial instruments like Treasury bonds or stocks. But there are important differences. A futures contract is a legal pact in which the purchaser agrees to buy or sell a certain amount of the underlying instrument at a set date in the future. That makes them incredibly risky, because the holder is required to live up to the contract no matter what's happened in the market.
For instance, a soybean farmer can agree to sell 5,000 bushels of beans in November 2002 for $44.70 a bushel using a futures contract from the Chicago Board of Trade. The upside could be great, but the downside could be devastating. The person who agreed to buy soybeans from our farmer at $44.70 a bushel in November 2002, for instance, would lose $23,500 if the market price were to sink to $40 by the time the contract expired. That's why we advise individual investors to stay away from futures altogether.
Option contracts, by contrast, give buyers the option of exercising the contract at their own discretion. In other words, they offer a choice. There are options on stocks, bonds, commodities, interest rates and currencies. For our purposes, we'll stick with stock options, since that's what most individual investors are interested in.
When you purchase an option, it gives you the right to buy or sell a certain number of shares of the stock in question at a predetermined price (the "strike price"), before or at the contract's expiration date. For this right, you pay the seller a fee, called a "premium," which is a tiny fraction of the shares' market value. During the life of the contract, you control the shares in question. Contracts can last anywhere from one month to three years. (Options more than nine months in duration are called Long-Term Equity Anticipation Securities, or LEAPS. They trade just like options.)
Puts and Calls
There are two kinds of option contracts: a put and a call. A put is an option that gives the buyer the right to sell the underlying stock; a call is an option giving the buyer the right to buy the underlying stock.
People generally use puts to hedge their bets. They're paying money now for the right to sell a certain number of shares later at a price agreed on today. Say, for instance, that in December 2001 you bought 100 shares of General Electric at $38 a share, and you wanted to protect yourself with a June 2002 put at a strike price of $35. That would give you the right to sell 100 shares of GE at $35 at any time until the contract expires.
The premium on that contract in mid-December 2001 would have been about $145. If GE were to fall to, say, $30 by June 2002, you could exercise the option and get out of the position at $35. You'd still lose $300 on the stock and $145 on the option premium, but without the option you would have lost $800 on the stock alone. Of course, the reverse could happen too. If the stock goes up to $60, you wouldn't want to exercise the option at all, and it would expire worthless. In that case, you'd have spent $145 on unnecessary protection.
Call options are contracts in which the buyer pays for the right to purchase shares at a certain date in the future. These are often used to take a long position in a stock without actually buying the shares now. For instance, say in December 2001 you wanted to cheaply add to your 100 shares of GE. You could have bought a June 2002 call with a strike price of $35 for around $760, giving you control of another 100 shares for a fraction of their market price.
