There has been lots of talk about the Apple share price recently, around how its gone from around $700 to $500 in the past 3 months, all with very little apparent reason. Gruber has a number of very good pieces on it if you are so inclined.
What I want to talk about is what’s going on here. Not the “conspiracy” side of it (and I’d not be surprised at all if Wall St is manipulating the price), but the mechanics of Options, as I think it’s something that a lot of people don’t know much about.
Stock – buying, selling and shorting
The concept of owning stock is easy: I want a stake in Apples future, so I buy 100 shares at $500 ($50,000 worth). Stock goes up, I make money. Stock goes down, I lose money. Easy. As a normal punter, I have no control over the price, and the price should be based on how the company is doing.
Should. It’s not, but it should. More on that later.
If I think Apple is going to go down, I can short sell (or just short) Apple. This means I borrow the shares from someone, sell them at $500, and when they go down to $450, I can buy them back (and give them back to the original owner) and make a $50 profit.
Of course, if they go up, I’m screwed – I have to pay $550 to buy them back, and then only get $500 back, losing $50, but thats what the traders get the big bucks for – risk management.
If the borrowing sounds odd (who’d loan their shares out?), remember this is all automated, brokerages require anyone shorting to have a cash balance high enough to cover losses, and the actual owner of the shares never knows (or cares) that “their” stock has been sold and then returned. It’s invisible.
In all this, I’m going to use Apple as an example, with a current price of $500. This is just as an easy, round-number example.
Options are what is called a derivative, as their price is derived from the price of the thing they are based on. Futures are also a derivative – their price is based on the price of the underlying commodity, eg the price of coffee. In the case of options, the underlying asset is the stock.
Investipedia has a nice definition which makes very little sense to the layman:
A option is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
So what does this mean? There are two sides to it.
I own some stock, I want to make some money on it.
Shares in the US seldom pay a dividend to the shareholders, and if they do, it’s not usually a large amount. So if you hold Apple, and want to make some money, you can create (write) an option. You literally sell a promise note, saying:
On Jan 15, I will sell the holder of this note my shares for $550, if they want them.
The components, which are in the definition, are the keys here.
- Jan 15: It has a specific expiry date. After this date, the note is worth NOTHING.
- sell: The action. I will sell my shares to the holder. This is a call option (the other is a put)
- $550: The strike price. What price I’m going to sell my shares at.
- if they want them: The holder of the note doesn’t have to buy the shares if they don’t want to. Infact, most (99+%) of options are never exercised (the underlying stock is never traded)
For this, I get a premium, like an insurance company does. The premium is based on the amount of time before it expires (time value), and the relationship between the option strike price and the shares current price (intrinsic value). Intrinsic value can go up. Time value always ticks down.
Options are very similar to insurance in this way, and hedge funds can use them to “hedge” or insure themselves against stocks going down:
I (the insurance company) will replace your phone if you break it before Feb 28. For this you will pay $5 for a phone of value $500. On March 1st, we renegotiate and you pay again.
If I do this – sell a call – I keep the premium regardless, and if the stock price is over $550 when the option expires, there is a chance the stock will be bought. If it’s under, the option expires, I keep the premium, and it all starts again.
This is called writing covered calls, as I cover it with the stock I own. You can also write naked calls, but unless you have an exceptional bank balance (Wall St), this is a good way to lose money.
This is what Wall St is said to be doing (they wrote a LOT of calls, and I suspect they were naked). If Apple closed at $500, and they wrote options at $500 or above, they keep the premium, and the shares. Easy money.
I want a stake in Apple, and I think they are going to go up, but I don’t want to shell out $500/share
For this, you might buy a call option. So if Apple is $500 now, and you think it’ll go to $600 before the middle of March (March 13 expiry), you would buy a March 2013 $600 Call. Options always expire on a specific friday of the month (3rd Friday).
Right now, the price of that option is $3.52 per share. I have to buy in contracts, and a contract is 100 shares, so if I buy 100 contracts, I have to pay $35,200. But I control $5,000,000 worth of Apple shares.
Time goes by. I can sell the option to someone else at the current price or keep it.
If the stock price stays the same, the option price will decrease over time, as the time component loses value. If the stock price goes up, the price of the option will go up (and down a little, as it still loses time value, but the increase in stock price offsets it).
If you are options trading, you sell it to make your money (and you can make 10-100% in 2-3 days if you do it right). If you want to own Apple stock, you can wait until it expires, and exercise it. But you’d need $5m cash sitting around (on the plus side, you’d then own stock worth $6m)
To give you an idea, if Apple jumped from $500 to $600 overnight, the option price is likely to go from $3.52 to around $30. Not a bad 10x return on your money. In reality, it might do that over a month or 2, so you would lose time value too, but the idea holds.
Puts are the opposite of calls. They are used when you think the stock will go down, and the contract looks like:
I will buy your shares at $450 on 15 Jan, if you want me to.
If Apple is at $500 on Jan 15, thats a great deal for the seller (they keep the premium and don’t have to buy the shares. No one would say “here’s a $500 share, just give me $450 for it”). If they are at $400, it’s not. If you buy a put (usually to offset an expected loss), and it hits $400, thats a great result for the buyer.
I hope that’s covered a bit of the basics of options. They are not overly complex or scary, but they can get you into a whole lot of trouble if you do it wrong, or get on the wrong side of one. I’ve not covered things like getting out of a contract (if you sold a call, you just buy one back at the market price to close it), but from what I know, the theory is solid.
I’ve also not covered Spread Betting which is very popular in the UK, as it’s not a “real” financial trading tool – it’s literally gambling against a casino.
I am strongly of the opinion that the stock market – mostly the big ones – are a bit of a casino. The “normal” player has no chance against the big boys and their computer-driven trading, who can get in and out of a trade before you even get the chance to buy. The stock price is also based not on “expected potential future earnings”, but just on the whims of analysts and traders with huge bank accounts, very large computing grids and 10ms ping times to the trading computers.
The other people trading the same stock as you are almost never “like you” – they have funds in the billions, and none of it is their money. Unless you buy and hold, you have no chance.
Now, just how many iPhone has Apple sold this quarter – thats the $5b question.