An Example of How Options Work

Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's Tequila Company.

Let's say that on May 1st, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the 3rd Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.

When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits–unless, of course, you think the stock price will continue to rise.... Say we let it ride.

By the expiration date, the price tanks and is now $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.

To recap, here is what happened to our option investment:

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action.

Exercising Versus Selling

So far we've talked about options as the right to buy or sell the underlying. This is true, but in actuality a majority of options are not actually exercised.

In our example you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.

However, the majority of the time holders choose to take their profits by selling (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE about 10% of options are exercised, 60% are closed out, and 30% expire worthless.

Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.

Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, is the amount that the price of the stock is higher than the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following:

Premium ($8,25) = Intrinsic Value ($8) + Time Value ($0,25)

In real life options almost always trade above intrinsic value.