The Four Specific Attributes Of Stock Options, Part 1
Filed under: Finance
These are the four essential pieces you need to see the whole picture, to know which option is being discussed, and to distinguish it from all other options. In evaluating risk and potential gain, and even to discuss an option, every buyer and every seller needs to have these four essential pieces of information in hand. Of course, because point of view between buyer and seller is going to be opposite, an advantageous situation to one person may well be disadvantageous to another. That is the nature of investing in options: You can take or the other for any particular option, depending upon advantage lies.
To review the four terms:
1. Striking price. The striking price is the fixed price at which the option can be exercised. It is the pivotal piece of information that determines the relative value of options based on the proximity of a stock’s market value; it is the price per share to be paid or received in the event of exercise. The striking price is divisible by 5 points for stocks traded between $30 and $200. When shares trade below $30 per share, options are sold in increments divisible by 2.5 and other issues end up with fractional values after a stock split. Stocks selling above $200 per share have options selling at intervals divisible by 10 points. The striking price remains unchanged during the life of the option, no matter how much change occurs in the market value of the underlying stock. (When stocks split, both striking price and the number of shares have to be adjusted. For example, after a 2-for-1 split, a $45 option would be replaced with two options of $22.50, and the original 100 shares would be replaced with 200 shares of half the value.)
For the buyer, striking price identifies the price at which 100 shares of stock can be bought (with a call) or sold (with a put). For a seller, striking price is the opposite: It is the price at which 100 shares of stock will be sold (with a call) or bought (with a put) in the event that the buyer decides to exercise.
2. Expiration date. Every option exists for only a limited number of months. That can be either a problem or an opportunity, depending upon whether you are acting as a buyer or as a seller, and upon the specific strategies you employ. The LEAPS provides more time, thus more flexibility on the time limitation. It also commands a higher premium as a result. Every option has three possible outcomes. It will eventually be canceled through a closing transaction, be exercised, or expire, but it never just goes on forever. Because the option is not tangible, the potential number of active options is unlimited except by market demand. A company issues only so many shares of stock, so buyers and sellers need to adjust prices according to supply and demand. This is not true of options, which have no specific limitations such as numbers issued.
Options active at any given time are limited by the risks involved. An option far out of the money will naturally draw little interest, and those with impending expiration will similarly lose market interest as their time value evaporates. Buyers need to believe there is enough time for a profit to materialize, and that the market price is close enough to the striking price that a profit is realistic; or, if in the money, that it is not so expensive that risks are too great. The same considerations that create disadvantages for buyers represent opportunities for sellers. Pending expiration reduces the likelihood of out-of-the-money options being exercised, and distance between market price of the stock and striking price of the call means the seller’s profits are more likely to materialize than are the hopes of the buyer.
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