Stock options are not for the typical investor - Sarasota Herald-Tribune

Stock options are complex securities not suitable for most investors; however, there is growing interest in them.

Stock options are not securities I recommend; however, it’s not unusual at the seminars I give that someone uses them. Before I show why, let’s understand them.

There are two basic kinds of stock options — calls and puts. The buyer of a call option on the stock of a company has the right to buy 100 shares of the stock from the seller for a fixed price, called the exercise price, until a fixed date, called the expiration date. The buyer pays the seller an amount called the premium. The buyer of a put option has the right to sell 100 shares of the stock of the company to the seller of the put option at a fixed price until the expiration date for the exercise price.

The premium on an option depends on two factors, the option’s “intrinsic value” and the time left until expiration.

For example, the intrinsic value of a put option depends on the amount that the exercise price exceeds the stock’s current price. If the exercise price of a put option is $52 a share and the stock is trading at $50 then the option has an intrinsic value of $2 a share or $200. Even if the stock is at $52 a share, this put option will have value based on the time left until expiration.

The problem with options for typical investors is twofold. First, the options market is not deep. For example, a stock like ExxonMobil may trade 4 million shares a day, while its options for a given strike price may trade only a few hundred a day. This means the bid-to-ask spreads tend to be much higher than for the stock, raising investors’ costs. Second, there are many highly skilled investors in the options market who know how to use sophisticated mathematical tools like a “Trinomial Tree” option value calculator.

Finally, let’s look at two examples.

John bought 1,000 shares of Oracle stock (ticker: ORCL) years ago for $10 a share. He watched it go to $59 a share and cycle down to $55. He still has confidence in the stock but is concerned that it may sharply decline. How can he use puts to limit his risk? He can, for example, buy 10 September 18, 2020 $55 puts. The premium recently was about $3,400. John has limited his downside risk in Oracle through September 2020, to $3,400.

If John were optimistic about Oracle but didn’t want to risk much money, he could use calls

He could have bought 10 September 2020 $55 calls. He would have recently paid a premium of about $3600. He has limited his downside risk to $3600. If ORCL is trading above $55 on September 18, 2020 he can exercise his option and buy it at the “sale price” of $55. Alternatively, he could just sell his options for their intrinsic value.

More detailed information is available at www.cboe.com. However, in my view, it’s not a good idea to use options without even deeper study.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

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Stock options are not for the typical investor - Sarasota Herald-Tribune
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