How can options be compared to shares if 1 option equals 100 shares?

Question

Question: Suppose you have 5000 shares worth $25.00 each. How can put options be used to provide you with insurance against a decline in the value of your holding over the next four months?

Answer:You could buy 5'000 put options with a strike price of $25 and an expiration date in 4 months. This provides a type of insurance. If at the end of 4 months the stock price proves to be less than $25 you can exercise the options and sell the shares for $25 each. The cost of this strategy is the price you pay for the put options

My Question: Wouldn't you buy 50 put options since 1 put option contract equals 100 shares?

Similar confusing question:You would like to speculate on a rise in the price of a certain stock. The
current stock price is $29, and a 3-month call with a strike price of $30 costs $2.90. You have $5, 800 to invest. Identify two alternative investment strategies, one in the stock and the other in an option on the stock. What are the potential gains and losses from each?

Answer: One strategy is to buy 200 shares. Another is to buy 2, 000 call options. Investing in options magnifies the potential gains and losses. If the share price does well, investing in options will give rise to greater gains. For example, if the share price increases to $40, the second strategy ends up in a gain of (2, 000·($40−$30))−$5, 800 = $14, 200, while the first strategy brings a gain of 200 · ($40−$29) = $2, 200. If the share price does badly, however, investing in options gives also a greater loss. For example, if the share price goes down to $25, investing in shares leads to a loss of 200 · ($29 − $25) = $800, whereas investing in options leads to a loss of the whole investment of $5, 800, since then the option would not be exercised.

My Question: Since 1 option contract equals 100 shares, why aren't you using the 200,00 shares in one strategy to compare to the 200 shares in the other strategy? Using options seems stupid since 1 option = 100 shares.

Another question: Am I confusing options with option contracts? I thought they were the same thing. I am terribly confused and cannot continue without understanding this concept.

Thanks for any help you can give.

Answer 1

Options are contracts nothing more, nothing less. Typically a put option would be a contract giving you the right to sell up to 100 shares at a specified price referred to as the strike price on or before the expiration date so to ensure a minimum price for your 5,000 shares, you would purchase 50 put option contracts.



There's a lot of confusion because option pricing are quoted per share not per option contract and a lot of people miss the whole point of options and simply use them to leverage their available funds so they consider purchasing call options as being equivalent to purchasing actual shares but at a much lower price hence equate purchasing one share with many call options. That is is a share price was $100 but a call option for that share was $1 a share, many people who've missed the boat on the benefits of options would equate purchasing 1 share with purchasing 100 options thinking that such leverage was a good reason for buying options.



So get away from using words like equals, an option contract equals nothing except the paper it's written on. It's a contract that gives you the right but not the obligation to participate in a trade. All options are contracts.



Note it's possible for a option contract to be for any number of shares that you wish to write it for and to expire on any date that you wish, it's just customary for them to be for 100 share lots and to expire on the third Friday of the month known as Freaky Friday. Occasionally you'll see options written for expiration dates other than the third friday, it's very rare to see them written for other numbers of shares.



Using options is far from stupid, If you bought a share at $100 and it went down to $90 you would lose $10, if it went up to $110, you would gain $10. If you bought a call option for $1 and put $100 in a bond that matured just before the option expired then if the stock went down to $90, you would lose the $1 but would still have your $100 plus interest from the bond, if the stock goes up to $110, you would use the money from the bond to buy the stock through the option at $100 and sell it to the market at $110 thereby making $10 plus the interest from the bond minus the $1 cost of the option. The efficient market hypothesis says that if all factors have been priced into the stock then there's a 50% chance it'll go up and a 50% chance it'll go down so if you had just bought the shares, your arithmetic expectation would be 0.5 * (-$10) + 0.5 * ($10) which is 0 while your expectation had you bought the call option neglecting the interest from the bond would be 0.5 * (-$1) + 0.5 * ( $10 - $1) which is $4 changing an investment where you can not expect to make any money to one where you can expect to make money. With investment, you try to find stocks that are undervalued by the market, that are being priced low due to situations that you consider to be temporary so that the stock price will rise (value investing), options gives you an added margin of safety and also allows you to make money on stocks that are not distressed. Not using options is stupid.



What you're missing is that with an option, you don't have to use it. If the stock price goes down then don't use your option, cut your losses and walk away from the money losing investment that you haven't made.

Answer 2

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Answer 3

Buying an option contract does mean 100 shares so, yes 50 contracts would be the equivalent of 5000 shares. Also if the price for the option is $2.90 you would have to multiply that by 100 to get the cost of the contract, so 1 contract would cost $290 plus commision. 50 contracts would cost $14,500. That would be true for either a put or call option. The 5000 shares of stock @ $25 would cost $125,000. If $2.90 was the price of a 25 put in your first example your total expense would be $139,500 (ignoring commissions)

A put option hedges your bet against a large drop in the stock price. If you hold until the expiration date and the price is equal to or below $25 your loss will be the amount you paid for the option. If the stock has gone up your profit would be reduced by the cost of the option.

If the stock went down $10/share your loss would only be $2.90/share. If the stock went up $10?share you would only gain $7.10/share.



A call option gives you extra leverage when the stock price goes up and limits your potential loss when the stock goes down. In your second example you could buy (ignoring commissions) either 200 shares or 20 call contracts. The call contracts would represent 2000 shares total. Your $5800 allows you to control 10 times as many shares. One thing you might do is commit less money by buying only 5 call contracts. You could use the remaining money to diversify and your maximum loss would be $1450. You could also use a mixed strategy by buying 100 shares of stock and 10 call contracts.

All the calculations below ignore commission expenses which are usually somewhat higher on option trades.

If the stock price on the expiration date was $20 buying the stock would lose $1800 or $9 times 200 shares. Buying options would lose $5800 as they would expire at $0. Options on 500 shares would cost $1450. The mixed strategy would lose $3800. Your $2900 in options would be worthless and the value of your stock would $900 less ($9 times 100 sh).

If the expiration price was $29 buying the stock would break even, buying options would cost $5800 or $1450 as your options would be worthless and the mixed strategy would cost the $2900 value of the options.

If the expiration price was $38 buying the stock would gain $1800 or $9 times 200 sh. Buying $5800 in options would gain $10200 as your 2000 options would be worth $8/share minus the $5800 you paid for them. Buying 5 call contracts would gain $2550 (500 times $8 = 4000 minus 1450). The mixed strategy would gain $6000 via $5100 on the options (8000 minus 2900) plus $900 in increased value of your 100 shares.

The value of options depends on the volatility of the stock. If the share price is flat options lose. If the share price moves strongly in the right direction options can gain alot. If it moves very strongly in the wrong direction options may gain by limiting the total loss.

Answer 4

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Answer 5

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