Examples of Options in Use

Example 1: Barry the Buyer and Stella the Seller

Barry owns ABC stock that is worth $100. He buys a put option that gives him the right to sell the stock for $90 anytime in the next 60 days. If the stock price drops to $70 before the term of Barry’s put option contract expires, he can exercise the option and sell the stock for $90, even though the stock is worth $70. Remember, for this example, Barry Buys Stock and Buys a Put. His Put option acted like an insurance policy. He paid a premium and was able to limit his risk.

Let’s think about the other side of the transaction for a moment. Stella sold the $90 put. When the stock dropped to $70, Barry’s exercise triggered an event called assignment in which Barry’s stock was transferred out of his account and ABC stock was transferred into Stella’s account. Stella is forced to pay $90 even though the stock is worth $70. Barry has the right to Sell for $90 even though the stock is worth $70. 

In this scenario, Barry defined his risk and lost $10 in the stock value. He also spent some money on the Put option. Stella received the stock at $90, which is worse than the market price of $70, but it’s still better than the $100 price that the stock had when she sold the Put. Additionally, Stella was paid for the Put option.

It’s important to note that Stella didn’t sell the put to Barry individually. Option contracts are publicly listed and processed through brokers, market makers, and the Options Clearing Corporation (OCC). The OCC is the buyer for every seller and the seller for every buyer and provides market stability and the guarantee of performance for standardized contracts.

Example 2: Ivan Sells a Call and Is Exercised

Ivan owns 100 shares of ATZ stock which is worth $120. He sells the 125 Call on the options exchange which means he will be obligated to sell the stock above $125. At the expiration of the option contract, ATZ is worth $131. Even though his stock is worth $11 more than when he sold the Call, he is obligated to sell the stock for $125, per the terms of his option contract. At expiration, his stock will automatically be “called away” from his account and he will be paid for the value of $125. Additionally, Ivan received a premium for selling this option. The amount of the premium can vary a lot with options. Hypothetically, we’ll say he received $1 per share for the option. So, Ivan made a total of $6 per share ($5 for the stock appreciation and $1 for the call premium received).

At this point, we can note that equity options (e.g. stocks, ETFs, and indexes) are traded in increments of 100 shares. One option contract represents 100 shares. The quotes are given “per share”. This means you can multiply the quoted price by 100 to get the dollar value of the option.

In this scenario, Ivan made $6 per share, or $600 total because he owned 100 shares and sold 1 Call.

Example 3: Tim Sells a Call and Isn’t Exercised

Tim owns ZZT stock which is worth $130. He sells the 140 Call for $0.75. The price of ZZT is $138 at expiration. Tim keeps his stock because the price of the stock at expiration was below the Strike Price of the Call. He also received the $0.75 per share, so Tim is actually more profitable than he would have been if he didn’t sell the Call.

On the other side of this transaction is Warren. He bought the same 138 Call for $0.75. Because this is an option on a stock, that means he bought an option for 100 shares. His total cost was $75 (plus commissions). At expiration, the Call was worthless and he loses the $75 he spent even though the stock went up after he bought the Call. He lost money because the stock didn’t go up enough to make the Call valuable at expiration. 

Example 4: David Writes a Put and Isn’t Assigned

David likes DYI stock but believes the price is currently too expensive. He decides to sell a Put contract which is 10% below the current price of the stock. At expiration, the price did not decline enough to assign him the stock at the lower price. David’s profit is the amount that he sold the Put for (less the commissions and fees). After expiration, David sells another Put and the same thing happens. Finally, after doing this several times, the stock drops low enough to allow him to be assigned the stock 10% below the previous month’s value. He received premium every month prior to this. This is often called “lowering the cost basis”. He not only was able to buy the stock for a 10% discount, but he also collected premium while waiting to do this. This effectively gives David an adjusted basis of 10% below the original value of the stock plus the value of the Puts he sold while waiting for this decline.