Of course, they didn’t have stocks back then, but they did have a thriving commodities trade.

Aristotle tells the story of Thales of Milesian, a mathematician and philosopher who used his knowledge of astronomy to predict a great olive harvest in the spring. He went to the people who owned olive presses — essential for extracting olive oil — and paid to reserve the presses when the harvest came. With no other business coming in, the press owners were more than happy to take Thales’ money.

Spring proved that his prediction was right on. Olive farmers took their bounty to the oil presses — only to discover all the presses were reserved for Thales. However, Thales was more than happy to let the farmers use the oil presses he had rented — for an exorbitant fee.

When it was all over, Thales had turned the good olive harvest into a fortune — without growing olives…and without owning olive presses.

Believe it or not, modern stock options work almost the same way.

When you buy a stock option, you are buying a contract that gives you certain rights for 100 shares of a particular stock. But don’t let the word “contract” fool you. They are standardized, so an options contract for one stock works exactly like the option for another stock. And since they are all alike, they can be bought and sold on the markets as easily as shares of stock.

There are two types of options contracts. A call contract gives you the right to buy a stock at a set price within a set period of time. A put contract gives you the right to sell a stock at a set price within a set period of time. The set price is known as the “strike price.” The set period of time is the “expiration date.”

For instance, let’s use a made-up company called ComTec as an example. If you buy a ComTec call with a $150 strike price with an expiration of January 2008, you can choose to buy 100 shares of ComTec for $150 anytime between now and next January — no matter what the going market rate is. (The act of redeeming your contract is called “exercising” it.) Even if ComTec shares are selling for $200 each, you’ll only pay $150!

Buying ComTec puts with a $150 strike price gives you the option to sell the shares for $150. So, even if ComTec shares fall to $100 each, you can exercise your put, and sell them for $150!

That’s why many people buy options as a sort of insurance, or hedge, to protect capital. The price of the option contract — called the premium — is usually a fraction of the cost of the stock. So for a little bit of money, traders can lock in today’s price for a stock — giving them the power to buy or sell it no matter what the price does down the road.

But some people buy options with no intention of exercising them. They’ll buy calls for stock they never plan to own…and they’ll buy puts for stock they don’t even know.

These people are the speculators — and they buy options for one reason: To make money, and lots of it!

Remember, options are tradable contracts — as easy to buy and sell as stocks. They also cost a fraction of the cost of actually buying the stock — but because they can be exercised at any time, their value closely tracks the stock price. And the standardized contracts give you control over 100 shares of the stock. So each dollar a stock moves is magnified by 100 in the option’s price.

In other words, options give you the power of Superleverage — a way to turn little moves into big profits, with an always known and strictly limited risk.

Of course, you can’t just buy any cheap option and wait for the money to roll in. In fact, time is actually your enemy. As I said, options have expiration dates. And after that day rolls around, your option is worthless…and you’ll lose every cent you paid for it.

So, if you want to buy an option, you need to figure out which stocks have the best chance for an unexpected move…determine which way the move will be…and make an educated guess on how long before the move happens. Then you have to determine if the option’s premium is worth the risk of you being wrong.

Luckily, there are two simple ways to judge an option’s value — intrinsic and extrinsic.

Intrinsic value is an easy-to-calculate number that immediately shows how much an option is literally worth. Simply compare the strike price of the option to the market price of the stock.

Let’s say ComTec is at $150 on the market. So for 100 shares, a $140 call will have $100 of intrinsic value. It is considered “in the money.” That’s because if you bought the call and exercised it immediately, you would enjoy an immediate profit.

A $150 ComTec call would have $0 of intrinsic value. You’d break even if you exercised it. It’s called “at the money.”

A $160 ComTec call also has $0 of intrinsic value. In fact, the stock would have to move $10 for it to have any value at all. This is called an “out of the money” option. (It works the opposite way for puts. A $160 put on a $150 stock is considered in the money, while a $140 put would be considered out of the money.)

As you’d expect, in-the-money options will cost more than at- or out-of-the-money ones. But that doesn’t mean the at- or out- options are bad investments. And it doesn’t mean they’ll be free. That’s because of the extrinsic value.

Extrinsic value shows how much an option is worth beyond its intrinsic value. It takes into account time and volatility.

The time component is relatively easy to understand. Remember, options are wasting assets. They have a fixed term of life and die a little every day, until they finally reach expiration and become worthless.

That’s why the closer an option gets to its expiration date, the cheaper it tends to become. As each day passes, option investors may not have time to recoup losses in a sudden turnaround. That risk can be reflected in the premium.

Longer dated options, of course, give you more time for the underlying market to move like you expect it to. That’s less risk for you and more for the writer…and that means a higher premium.

Again, easy enough to understand and calculate. In fact, if these were the only factors that determined an option’s premium, there really wouldn’t be a reason for speculators to buy them at all. All the profit potential would be carefully calculated for you already. Luckily for traders, volatility also plays a role in an option’s extrinsic value.

Volatility, of course, is how prone a stock is to up and down markets. It makes it difficult to tell which way a stock is moving. That uncertainty figures into an option’s price. So if a stock seems certain to go up, the premium will be lower.

This is where the speculations are made. If you’re certain a stock is going the opposite of where the market is going, you can buy cheap options on it. As a speculator, your analysis doesn’t even have to be dead on. Even if the stock just starts to move unexpectedly for just $1, it’s enough to boost an option’s extrinsic value by at least $100.

Sell at the right time, and you’re looking at the phenomenal payday.

There is so much more to options than I have space to explain here. But I encourage you to learn as much about these powerful moneymakers as possible. They’re really not too difficult to understand, and they’re a great way to add some oomph to your portfolio!

Sincerely,
Steve Sarnoff
May 1, 2007

Investing with Options Plays was originally featured in the Penny Sleuth.