Une Part: Stock Options

I have had a number of requests regarding some sort of article on a topic many my age know little to nothing about. Investing.

Stocks, bonds, mutual funds, CDs, 401Ks. If you haven’t heard of these terms, I suggest you open your eyes… and quick. You could attempt googling “investing strategies” until your fingers fall off. Or your could peruse the business section in Barnes & Noble with a latte & an open mind. Or for starters, you could read this blog.

Ever wonder how people turn $1,000 into more than 5 times that amount? It’s called investing, my friends. And I’m going to give you an introduction to it. (Thank you W.P. Carey School of Business for making me and my fellow colleagues uber savvy in this area.)

First of all, what exactly is stock? Stock is an instrument that signifies an ownership position (called equity) in a corporation, and represents a claim on its proportional share in the corporation’s assets and profits. Ownership in the company is determined by the number of shares a person owns divided by the total number of shares outstanding. Huh? Let me break it down for you. A stock represents a small ownership piece of a company. There, that wasn’t so bad, was it?

Now that we know what stock is, let’s move forward. Stock options provide investors with additional opportunities for potentially rewarding returns. BUT stock options do possess risks that require an in-depth understanding of how they work. Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options to hedge against (avoid) a price decline, to secure a future purchase price, or to speculate on the future price of stock. Employees usually receive stock options through a compensation plan. These options have the potential for value growth and the possibility that this high value will be taxed at a favorable rate.

What are stock options? A stock option is basically a contract that gives one party the right to purchase or sell a stated number of shares of stock at a specified price. Layman’s terms: Sally bought 4 shares of Wal-Mart’s stock & now “owns” a small portion of the company. Sally can either keep her stock, or ideally, sell it once the price/value increases in the market. So that’s why those crazy investors frantically run around on their cell phones at the NYSE…

The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years until the expiration date. If not exercised on or before the expiration date, the option expires.

What forms of stock options are there? They come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.

Here’s where it gets tricky. A call option is valuable only when the exercise price is below the market value of the underlying stock. For example, if a stock is being traded at $100/share and you hold a call option which entitles you to buy the stock at $72/share, your option has an immediate value to you of $100-$72= $28. This is a smart idea because you end up “making money”- $28 on that specific share.

Now that we understand that, a put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with an exercise price of $90 and the stock price moves to $80, you may choose to exercise the option and sell that stock at $90 for an immediate per share gain of $10. Because $90-$80 is $10.

With both calls and puts, the purchaser has the right to exercise, while the seller is obligated to respond if the option is indeed exercised. The purchaser would then have to pay a premium (or upfront fee) to the seller in return for the right of exercise. The buyer now has a known investment risk- if the option expires unexercised, the purchaser recognizes that premium paid as a loss. Conversely, the seller takes on unlimited market risk in return for the premium received.

I think that is enough for today. I’ll allow this mumbo jumbo to sink into your overworked, exhausted cranium. Une Part complete. La deuxieme partie will commence tomorrow. That means part two.

Nerd on.