Smart Saving and Investing

An option is a contract that provides you with the right to buy or sell 100 shares of a stock.

Typically, one option contract represents 100 shares of stock. An option gives you the right to buy or sell 100 shares of a specific stock for a set price on a set date. You can do this without owning the stock.

However, think of an option as an ice cube. With every passing day the option becomes worthless. The option is a decaying asset that ultimately ends up being worth nothing - $0.00.

There are two kinds of options, a call option and a put option. One call option indicates you want to buy 100 shares of stock and one put option indicates you want to sell 100 shares of stock.

Let’s say you want to buy one option contract on the stock Pozen Inc, symbol POZN. Pozen is a pharmaceutical company that focuses on various pain-related conditions such as acute and chronic pain.

First we determine if we are buying the option contract because we’re bullish on the stock, in other words we think it will go up, or we’re bearish on the stock, we think it will go down. In this example, we’ll be buying a call option which means we’re bullish on the stock and we think it will go up.

We think POZN is going to go up because we’ve been following the “smart money” and it looks like there’s a lot of interest in the September 10, 2007 call options. When I say “smart money” I am talking about the institutional investors. Those are the investment teams who have huge amounts of money to move markets. The Fidelity, Vanguard, and T. Rowe Price types. Notice the volume below in the red square. So we’re looking at the call option listed at BigCharts that is labeled QKZIB.

The price of the stock closed at $8.79 a share as indicated in the “Strike Price” column that is dark purplish. The strike price we think the stock will go to or past is $10.00 a share. Using our opening definition above of an option has a set price, the strike price then is our set price. We are betting our stock POZN will make it to $10.00 or more a share by the third Friday in September 2007.

The third Friday of every month is Options Expiration day. That is when your option expires or is no longer valid. At the end of the day for most options. That is the part of our opening definition explained above, an option has a set date and it’s the third Friday of every month.

So hang with me here. If we buy one contract for 45 cents (see the column to the far left of the red square below labeled “Last”), we are actually taking 100 shares times 45 cents. That comes to $45.00 to buy this one contract of POZN to control 100 shares of stock - 100 x .45 = $45.00.

Now, imagine buying 100 shares of POZN for $8.79 a share - 100 x 8.79 = $879.00. So you can immediately see that to buy the 100 shares at $8.79 a share would cost us $879.00 and the call option would only cost us $45.00 to “control” 100 shares of POZN.

At this point, let’s clear our minds and empty our brains. Here’s what we’re thinking at this point:

We want to buy the September, 2007 call option on the stock POZN that has a strike price of $10.00. We think the stock will go up to $10.00 a share or more. We are going to pay someone who owns those 100 shares of POZN $45.00 to reserve that price for us. That way if the stock goes above $10.00 a share (our strike price) we’ll be able to buy 100 shares of the stock for $10.00 a share.

So the “somebody” who sells us the call option is really selling us what’s called a covered call to the seller. We’ll discuss covered calls in another post.

Again, for that right that we get to purchase POZN at $10.00 a share, we’re paying someone $45.00.

What we’re really doing here is hoping the stock goes up because the value of the call will (should) also go up. That is all we’re interested in, really. If we make a profit on our call option, then we’ll bail (sell it).

So we stay true to ourselves and not get lured in by what could come of this option, we need to set a target of what we want to make before we close this position. For this example we’ll say, if we make 25% on our money, we’ll close the position by selling it. Remember, “pigs get fat, hogs get slaughtered.”

This is an aggressive play because we only have one month until the third Friday of September 2007. As the trading days go by, our melting ice cube of an option will lose value. That value is calculated based on a rather complex mathematical formula that goes beyond this post.

Now, I haven’t even talked about things like technical analysis or fundamental analysis. When we’re playing options, usually we don’t care about the underlying company. We’re just hoping the stock moves in a big way up or down. In this example, we want POZN to move up, up, up.

So that’s what we’ll do for the next few days is hope that our stock moves up. With the volatility in the markets lately we should find out pretty quick. We’ll do what’s called paper trading, which means we really won’t place this trade. We’ll just write it down on paper and watch.

Cross your fingers and get the bubbly ready.

written by Bill Stevens