What are Stock Options? – The Ultimate Guide for Beginners

Wall St. Nerd

A.Kelm

Updated on

January 13, 2023

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Did you know that Warren Buffett trades in stock options?

You do not have to be an options trader to be a value investor. However, the right kinds of options trades fit wonderfully with the value investing strategy and can increase your portfolio's returns. Options trading, when done right, can even reduce the risk of owning stocks.

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Before we dive in, it is worth saying that you should always apply value investing principles when investing, even with options - because if you don't want to own a company for 10 years, you shouldn't own it for 10 minutes either.

Now let’s get started.

What are stock options?

Definition of stock options: Stock options are contracts that give the buyer (the option holder) the right to buy or sell shares in a certain company at a certain price (depending on the type of option) within a certain period of time (on or before the expiry date).

The options themselves can also be bought and sold.

Now there is a lot to cover, so let’s talk a little more about how stock options work.

How do stock options work?

Stock options consist of contracts made up of an underlying block of shares - typically 100 shares.

When you trade in stock options, you are essentially betting that the price of the stock will go up or down (depending on the type of option) by the expiration date.

Stock option basics

To give you some context, let us assume you are selling a stock option.

The person who buys the stock options from you pays you a fee called a premium.

Depending on the type of stock option, the premium the buyer pays gives them the right to either buy or sell the stock. We will discuss this in a bit more detail later, but for now, just understand that there is either the option to buy or sell, but not both.

If the buyer decides to buy or sell the stock by the expiration date, then the buyer is said to be exercising the option.

As the seller of the option, you get to keep the premium whether the buyer has exercised the option or not.

Example of a stock option

An original format of options was created so that farmers who had grown their wheat were not exposed to the risk of a large price drop.

The price drop would cause farmers to lose money when the wheat was ready to be harvested.

Therefore, farmers would have to find someone willing to be on the other side of the trade. Since the farmer is a wheat seller, he would want to find a wheat buyer - such as a baker.

The baker might want to lock in the price of the wheat in June, even though he cannot get it until September - and now both sides are guaranteed a fair trade when the wheat is ripe and harvested.

Stock options are supposed to work exactly the same way, only instead of selling the right to a bundle of wheat, we sell a block of shares.

The difference between buying shares and trading options

You buy and sell stock options on the same exchanges where you buy and sell shares.

However, there are some key differences between investing in stock options and investing in shares in wonderful companies.

One major difference between shares and options is that shares give you a small piece of ownership in a company, whereas options are just contracts that give you the right to buy or sell the share at a certain price by a certain date.

Another key difference is that options contracts are not held for the long term - AND you know as a value investor when we buy shares that we intend to hold them for a long time.

Options are not a risky thing to begin with. It depends on the overall market and how you use them.

Now that you understand the basic principles of options trading, let us cover the two types of stock options and how they work.

Types of option transactions

There are two types of options - call options or put options.

The basic difference between the two is that in call options, the buyer of the option gets the right to buy the underlying shares and in put options, he gets the right to sell them.

What is a call option?

Call options are a fantastic way to generate cash flow and reduce the cost base of companies we already own.

We say that a call option is a value investing call option if we already own the underlying stock. Let me briefly explain how call options work.

Call option definition: A call option is a contract that gives the buyer the right to buy shares or another asset (the underlying) from the seller at a certain price (called the strike price) within a certain time (until the expiry date).

How do call options work?

The easiest way to understand call options is to consider a similar situation. You can think of a call option as a coupon that someone would take to the grocery shop to buy a gallon of milk at a set low price.

In this example, instead of clipping the coupon from an advertising circular, the buyer would pay the grocery shop a very low price for the coupon.

In this transaction, there are two parties, the buyer of the coupon and the grocery shop.

The buyer of the coupon gets the right to buy one litre of milk at the set price. If the buyer decides to redeem the coupon, the grocery shop is obliged to sell the milk to the buyer at the set price.

Whether the buyer buys the milk or not, the grocery shop gets to keep the price, the buyer paid for the coupon.

Call options work in a similar way.

When you buy a call option, you get the right to buy the underlying stock from the option seller at the set price for a set period of time.

If you are the seller of the call option, you become obligated to sell your share to the buyer at the specified price if the buyer requests it within the specified time.

Selling Call Options

Why would we as value investors want to sell call options?

If you own a company and sell someone the right to buy your shares at a price higher than you think the shares are worth, there is almost no risk at all. If the share price rises to this unexpectedly high price, you would want to sell the share anyway. You should always aim to sell in greed and buy in fear.

When greed drives the share price up like a rocket, you want to be a seller of that share. You can increase your cash flow by selling call options that give the buyer the right to buy your share at a set higher price.

The buyer pays you a premium for the option, and you can put that money in your pocket.

If the share price goes up above the set price, you sell the shares to the buyer. If the share price does not go up, you can keep the money that the buyer paid you as a premium. Either way, you win.

We love selling call options as value investors when we already own the stock.

There is virtually no risk, and we get more money for selling shares we would have sold anyway.

How call options work when you are the seller

Suppose you own 100 shares in the company Wall St. Nerd. Its current share price is USD 105 per share.

Based on your assessment of the company's intrinsic value and current market conditions, you believe that it is unlikely that the share price will rise above USD 112 per share in the next month.

You look at the option quotes and choose a call option for 112 with a premium of 35 cents and an expiration date next month.

You sell a contract and the buyer pays you a premium of USD 35 (0.35 x 100). Whether the share price goes up or down, you still make a profit.

If the share price rises above USD 112 per share, the buyer will exercise the option, and you will have to sell your 100 shares at USD 112 per share, which is USD 7 per share more than they were worth when you sold the option.

If instead the share price never rises above USD 112 per share before the expiry date, you will keep your shares and the premium, too.

How call options work when you are the buyer

Let us say you buy 10 call option contracts with an issue price of USD 150 per share and a premium of USD 12.

The total premium you would pay is the premium price x the number of contracts x 100, which in this case is USD 12,000.

If the share does not rise above the issue price of USD 150 by the expiry date, then you would receive nothing and would lose your entire premium.

However, if the price per share rises above the sum of the issue price and the premium price (USD 150 + USD 15= USD 165) on or before the expiry date, then you could exercise your option and buy the underlying share for USD 150 and would be able to buy it for less than its current market value.

What is a put option?

A put option is the opposite of a call option.

Definition of a put option: In a put option contract, the buyer gets the right to sell the underlying stock to the option seller at the specified price within a specified time, usually a month or so.

With a naked put, you do not have to sell the underlying shares short.

When you sell a put option, you are willing to buy the stock at a price lower than what it is selling for at the moment.

While you wait for the price to fall, you earn some income and if the price falls, then you would be willing to buy the stock from the option holder at the lower price.

How do put options work?

A put option becomes more valuable when the price of the underlying share falls.

Selling naked puts is a very good strategy if you have absolute confidence in the value of the company.

The problem with selling a naked put in the current market is that you may have to buy the stock at a price quite a bit higher than the price at which the stock is sold - and that hurts.

Let us take an example: The ABC share is selling today for USD 30 a share. You like it a lot for USD 20, so you sell someone the option to sell you the share for USD 20.

They pay you USD 0.50 for this option. Then the share starts to fall like a brick to USD 15. Then the option holder demands that you buy the share for USD 20. You have to, and so you are immediately 30% down.

And that's the reason why I'm not a big fan of naked puts.

The risk of naked put options

For me, it is mostly psychological. I love being in the money and seeing the price of a company I want to buy crash.

It is as I am a hamburger lover (I am) and the price of the burger goes down, down, down. I LOVE it! My beloved burgers are getting cheaper by the day and since I am a burger lover that is a good thing for me.

However, if I set a limit on how cheap they can get by selling an uncovered put, I just want the burgers to drop to that price and no further. That is pretty hard to do - nail down the bottom price of something.

Especially as we know, that Mr. Market is sometimes quite irrational, especially when he is panicking and scared. Mr. Market is perfectly capable of quoting a ridiculously low price for a great business.

It is just terrible to have to pay more when Mr. Market is so cooperative. He offers us a massive discount to sell below its true value.

And fortunately or unfortunately, this happens a lot: if we sell the option at a price that is a nice margin of safety, we can't be sure that Mr. Market won't completely panic and sell way below the safety price.

I have seen Mr. Market do just that time and time again.

Example of an uncovered put option

For example, in 2001, Valero, a wonderful oilfield company, was worth about USD 20 and it sold for USD 7. Urban Outfitters was worth USD 6 and it sold for USD 2.

And there are more extreme examples that come up from time to time when the markets do what they do - fluctuate.

If you had sold the put option on Valero at the margin of safety price of USD 10 or Urban Outfitters at the margin of safety price of USD 3, you would have had to start your position about 30% lower.

Therefore, it is important that you really know what you are doing before you trade options and that you have a solid understanding of the intrinsic value of the company.

How to trade options

The basics of trading stock options are to first choose the stock you want to use as the underlying asset. Then you need to do your research and decide whether you think the share price will go up or down.

And then you look at the available option prices, which will give you a choice of combinations for strike prices, expiry dates and premiums.

As I mentioned earlier, trading stock options is not a risky thing to do in the first place - but they can be risky if you do not understand what you are doing.

It really depends on the overall market and how you use them.

There are some options strategies that are particularly well suited to value investors, such as the collar, where you buy a put and sell a call - a strategy that limits your risk if the share price falls and still lets you profit if the share price rises.

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Hi, I'm Alexander Kelm.

Serial entrepreneur, value investor and angel investor. Founder of Wall St. Nerd. Join me here on wallstnerd.com to learn how to read financial statements, find healthy companies, and invest your money wisely.


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