Stock Option

An overview of Option Terminology and trading in Stock Options.

Like any investement there are some factors that we need to consider when purchasing stock options, most of these factors we consider on a daily basis some of course are instrinsic to trading however they will form part of your thinking in no time.

Duration of the Stock Option.

Usually determines the cost of the stock option, the longer the duration the more the stock option will cost, the opposite is true with a short duration, if you wanted to control an asset for one day then the price of that will be less than the price for the asset you want to control for a year or so.

There is a simple reason why the duration of an asset affects its price.

The longer you have control of an asset the more liely hood that the price of that asset will be affected by certain historical factors.

For example, if you buy a piece of real estate in a town somewhere it is highly unlikely that the price of that land will increase drammaticaly overnight ( unless you find gold or oil on it ) however in the next 5 or so years the same piece of land may increase in value overtime as the town develops shopping centers are constructed, schools are built and more people move in to the area.

So if you wanted control of the stock option on this real estate for 5 or so years you would pay more for it for the reasons given above.

As the duration of the stock option increases, the value of the option also increases.

Strike Price: 

It is the price agreed upon by the option buyer and the stock option seller at which time the stock option buyer can exercise their right to buy the asset.

There are factors that come to play when a stock option can be exercised.

Lets say you want to buy a stock option to buy some property. You can accept an agreement price to buy the property at $200,000 or you can agree to buy it at $300,000. If both options cost the same the most attractive one to buy would the the property that is at $200,000.

Why is this? Let’s assume that the properties value increased to $250,000. If you had the righ to buy the property for $200,000 you could “exercise” your right, that is to purchase the property for $200,000 and then sell it for $250,000 thus earning a profit of $50,000. If, though you had the right to buy the property for $300,000 and you “exercised” your right to buy that property at $300,000 then sell it for $250,000 you would make a loss, so of course you would NOT “exercise” your right to buy that property at $300,000 if the value of the property was only $250,000, you would do nothing.

This shows how a stock options price would go either increase in value or decrease in value, depending on the agreed price at which the stock option can be exercised.

Let’s take a look at the current value of an asset and why it is a factor when exercising a stock option.
Let’s say that you wanted an option to buy a piece of property for $200,000 (commonly known as the strike price ) within the next 12 months, the property at the moment is only worth about $80,000, so you buy the option and in 12 months the value of the property goes up to $160,000, you now own the option to buy that property for $200,000 but even though the property value has doubled to $160,000 you would still not make any money, so you would NOT exercise your right to purchase that property.

However if the property was valued at $160,000 to start with and then within that 12 month period the property value went up to $320,000 then you would exercise your option to buy the property for $200,000.
You would then exercise your right to buy that property for $200,000 and then immediately sell it for $320,000 making a profit of $120,000. ( $120,000 is referred to as the intrinsic value of the stock option )

It’s that simple, so this shows how the current price of an asset ( in this case the property ) affects the value of an option. In the case of the second example the price of the asset was closer ($160,000 ) to the “exercise” price ( $200,000) of the asset giving the stock option a high value. The further the asset price is of the exercise value, such as in our first example the less value the stock option has, even though the value of the asset (the property ) had doubled in value.

So an stock options value is affected by time a price of an asset.
Remember too that you have to weigh up other factors when considering the value of an option, such as the money you have to fork out for the stock option, if you have to pay $10,000 for the stock option to purchase the land in 12 months time then you have that $10,000 tied up, you are not getting any interest on it, buying the stock option also costs you some form of lost income, in this case you are not getting the current interest rate on your $10,000 if that $10,000 was in the bank at a rate of 7% return. This is known as the “opportunity” cost.
That is how much of a definite income you are sacrificing by investing in an option instead of leaving it in the bank and getting that 4% return for it.

The upside to this of course is that you get to control an asset with very little money up front, so instead of having a huge amount of money tied up like one would normally have done as a “deposit” for a block of land, you only have to fork out a minimal amount for the stock option or the right to buy that land at an agreed price. You can then use the rest of your money to invest it somewhere else, so in some ways it reduces or eliminates the opportunity cost of owing that asset.

In options trading the block of land we used as an example (the asset ) is called an underlying asset.

Another factor that affects the value of an option is the likelyhood of the underlying asset gaining value, if Wall Mart, McDonalds and Donald Trump were starting to build around the area then your asset is more than likely to go up in value than a piece of property with the same strike price out on the mountains where life was a bit slower and there was little or no development happening.

The choice here is simple, if you had the opportunity to control both assets with equal risks, you would go for the land that was likely to increase in value in a shorter amount of time than the one that will not.

The probability of the reward for the first piece of land is greater than the second piece of land that is in the mountains, even if the option to buy it was for 5 years there would be a better chance that the value of land in the area where McDonalds and other were building would go up at a much higher value rate than the one in the mountains.

So then the thing to remember is this, stock options on assets with a high reward potential will tend to have more value than options on assets with a low reward potential.

The things that affect the value of an option are, the duration of an option, the price of the option when it is exercised, the current value of the asset, the opportunity costs, the reward potential and the risk potential of the asset.

Stock Option