What is an Option?

Background

In this article we established that investing in the stock market is a good idea.

In this article we learned how to invest in the stock market. This article also points out that selling covered call options on the SPLG investment is a good way to outperform the stock market. So, in order to understand how to sell a covered call, we need to begin with: what is an option?

What is an option?

An option is a contract that gives the owner of the contract the right to buy or sell a security at a predetermined price. The option contract we’re interested in is a “call” option.

For our purposes, a call option is an option that gives the owner the right to buy 100 shares of stock at a predetermined price, by a specific time. The predetermined price is called the option’s strike and the specific time is called the option’s expiration date.

It is helpful to compare a call option to buying a house. Suppose you see a house that is listed for below what you think it could sell for. Perhaps the house is listed for $100k, but you believe that in one year’s time, the house will be worth $120k.

You could buy the house, and then wait for the price to appreciate before reselling it. But that would take a large amount of capital.

So instead, imagine if you bought a contract that gave you the right to buy the house for $100k in one year. We’ll say that the contract costs you $1000.

Then, imagine that the price does go up to $120k after a year. Your contract would now be worth $20k. Why? Because you could exercise your right to buy the house for $100k, and then turn around and resell it at the current market value of $120k (a $20k gain), giving you $20k in instant equity – and that $20k instant equity would be priced into your contract.

Trading the contract, instead of the house outright, is advantageous for two reasons. First, you capture the profit of the house’s appreciated value without the hassle of buying and selling the house outright.

The second advantage to trading a contract instead a house itself is that your risk is smaller. Think about the worst case scenario: if the house were to burn down or something, then its value would go to $0. When trading the contract, you’re only out $1000. But if you’d bought the house outright, then you’d be out $100k.

The low risk aspect of trading contracts instead of houses also improves your return ratio. If you’d chosen to buy the house for $100k and sold it for $120k then you would’ve made a 20% profit. But when you buy a contract for $1000 and sell it for $20k, your investment returns 20,000%!

In our illustration, your contract giving you the right to buy the house for $100k is like a call option. If you own that contract then you own the right to buy the house for $100k, even if the value of the house increases.

Also in our illustration, the $100k price point is equivalent to the strike for an option.

Now let’s solidify the concept of options. Suppose you see a company whose stock is selling for $50, but you believe that their stock is undervalued and could quickly go up to $60. Instead of buying 100 shares of stock at $50 each ($5,000 total), you buy a call option for $100. You choose a strike of $50, meaning that you now have the right to buy 100 shares of stock at $50, no matter how high the share price actually goes.

Time passes and you’re a fortune teller; the stock price does go up to $60! How much is your option worth now? $1000. Why? Because if you exercise your right to buy 100 shares of the stock at $50/share, and then turn around and sell those shares at the current market value of $60 per share, you’ve made $10 per share times 100 shares = $1000 profit. And that profit is priced into the options contract.

Time Decay

An important feature of options is that the further out the expiration date, the more expensive the option will be. Why? Because more time gives you more opportunity to make money. And you need to pay for that opportunity. This is the concept of time decay. If the price of the underlying stock stays the same (and all other things remain equal), then an option will lose value over time.

Let’s illustrate the concept of an option’s time decay. Remember the illustration above, where you bought a $50 strike option with the hopes that the share price would go up? For simplicity’s sake, let’s assume that the stock trades flat. If the share price is still $50 when your option expires then your option would now be worthless. Why? Because there’s no value to buying an $50 strike option and exercising the option in order to buy the stock at $50 when the share price is $50 anyway. It would be easier just to buy the shares outright.

It is this time decay that powers the profit of a covered call strategy. Read on to the next article to learn more about how the covered call strategy works.