An Introduction to Stock Options

Here we will help you get a handle on what stock options are and how they work.  The game of buying and selling stock options began in 1973, when contracts were standardized and started trading on the Chicago Board Options Exchange (CBOE).  Let me walk you through my first options transaction in the summer of 1973 to make things simple for you.  The game works the same way today.

I was young and willing to speculate, but wanted to get a feel for things before I played the riskier options.  ABC (fictitious) was trading at $50 a share.  I wanted to bet that it would rise in price, and I wanted to double my money in a few days or weeks.

In early June I bought one options contract on ABC:  the July 45 CALL.  My cost was $550 plus commission of $25.  ABC stock was trading at $50.  Now let’s walk through this thing.

What I paid $550 for was the right to purchase 100 shares of ABC at $45, anytime between that moment and the third Saturday of July (when the option would expire).  The last day I could sell the option was on the preceding Friday (options that are about to expire quit trading at the market close on the third Friday of the contract month).

Now, the real value of the stock option when I bought it (called the intrinsic value) was only $500.  This is because I had a right to buy 100 shares of ABC at $45 for a total cost of $4500.  Since the stock was trading at $50 per share, 100 shares were worth $5000.  In other words, theoretically I had a right to buy 100 shares for $4500, and could then immediately sell them for $5000 and pocket $500 (minus commission).

We will not get into theory here.  We are keeping it simple.

Why would anyone pay $550 for something worth only $500?  ABC stock went up $5 over the next few weeks to $55.  That was a gain of 10%, going from $50 to $55.  My options contract did much better.

When I bought one options contract on the ABC July 45 (call), it was quoted at $5.50.  Multiply this times 100 to get the cost of $550 that I actually paid.  That’s how it works.  With ABC at $55 per share, my stock option was trading at just above $10.  This means that I could have sold my contract (all contracts are for 100 shares) for just about $1000.

Instead of making 10% on ABC stock, I could have made almost 100% on the stock option.  That’s why traders play stock options.  I could have sold and made $500 on a $550 investment (speculation) in a matter of weeks.

As things turned out I held my stock option a while longer.  I sold it when ABC was down to $51, and got $6 for my options contract.  How did I do?  I received $600 ($6 x 100), and I had paid $550 for it.  Commission was $25 each way, so I broke even.

That’s as simple as I can make it.  This was only an introduction to the subject of stock options.  Books have been written on the subject.