Money Rehab with Nicole Lapin - Double Clicking on Call Options

Episode Date: February 3, 2022

We know— call options are pretty confusing. Today, Nicole digs deeper into the concept and walks us through different hypothetical scenarios and outcomes. You’ll be an option pro after today’s episode! Learn more about your ad-choices at https://www.iheartpodcastnetwork.comSee omnystudio.com/listener for privacy information.

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Well, it doesn't. Charge for wasting our time. I will take a check. Like an old school check. You recognize her from anchoring on CNN, CNBC, and Bloomberg. The only financial expert you don't need a dictionary to understand. Nicole Lappin. Welcome back to our very exciting deep dive into call options.

If you didn't listen to yesterday's episode, I would highly recommend you take a moment to check it out before we get started. Yesterday, I gave a primer on the topic, and today we're going to be jumping in with both feet. So let's do this. For these examples, we're going to follow a money rehabber we'll call Lily. Lily likes piña coladas, getting caught in the rain, and stock options. Let's pretend it's New Year's Day, January 1st, 2022, and one of Lily's New Year's resolutions is to make her money work for her. Yay! She's interested in buying a stock in the company called The Money Rehab Company. Best company ever. Right now, the stock price of The Money

Rehab Company is $15 a share. She thinks that this company is incredible, duh, and that the stock price is going to climb in the next few months, double duh. She goes online to her brokerage and she looks at the list of people selling money rehab call options. She'll be able to see the different stock prices she'll have the option to buy for a certain expiration date. Those prices are called strike prices. For example, Lily might see that she can secure the option to buy the Money Rehab stock at $20 a share by March 17th. But Lily can't just take this option for free. That would be too good to be true. Lily has to pay for this option. And that's where the ask comes in. The ask price is the price per share that Lily needs to pay today to secure the option. Let's say that

ask price is five cents a share. A very important thing to know about stock options is that they're typically sold as a bundle of 100 shares. And yet, when you look at your pricing options online, you're going to see prices per share. So remember, even though it looks like Lily is buying the option to buy one share at $20, she's not. We're talking about multiples of 100 here, so don't get it twisted. So the full story is that Lily would need to pay for 100 shares at the ask price of 5 cents a share in order to have the option to buy 100 shares of the money rehab company at $20 a share. So what will Lily actually pay for the option? It will be the ask price times 100 shares or 5 cents times 100 or five bucks. Remember, this $5 is not a down payment. This is the amount that Lily pays to purchase the option. If she exercises the option, this $5

does not count toward the price Lily needs to pay to buy the stocks at the strike price. And if Lily does not exercise this option by the expiration date, March 17th, she does not get the five bucks back. If Lily buys the option, a few different scenarios could pan out. Let's look at a situation where she does want to exercise the option and an alternate scenario where she lets the option expire. Scenario numero uno. Spoiler alert, this scenario means more returns for Lilly. Lilly wakes up on March 17th and sees the money rehab company's stock trading at $25 a share. Investors typically exercise call options if they have the option to buy a stock at a lower price than the stock's market price, because essentially what that means is that they get to pay less

than what the suckers on the open market are paying for the same stock on the same day. Or in other words, they get to buy the stock for a discount. And who doesn't like a discount? By the way, when the market price is higher than the strike price for the call option, it's called being in the money. That one is easy to remember because it doesn't take a lot of brainpower to wonder whether being in the money is a good thing or a bad thing. And we, of course, want to be always in the money. In this scenario, the market price for the money rehab stock is trading at $25 a share. So Lily will say, hell yes, you bet your bottom dollar I'm exercising my option to buy this stock at $20. Of course, exercising the option to buy the stock does mean

that you have to, you know, buy the stock, which is going to cost Lily $20 per share for 100 shares. But again, she is getting the stock at a discount. So now let's look at scenario numero dos. Spoiler alert, this means less returns for Lily. Lily wakes up on March 17th and sees the Money Rehab stock trading at $16 a share. Yes, the value of Money Rehab stock is up from the price where Lily bought the option, $15, but that doesn't matter to her. The only thing that matters to Lily is whether the market price on the expiration date, which is $16, is higher than what she has the option to spend, which is $20. In this case, no. Thankfully, Lily just paid for the option to buy 100 shares at $20 a share and does not have to buy them.

As we know, with call options, when the stock price has exceeded the strike price, it's said to be in the money. In the situation like scenario B, where the strike price is higher than the market price, the option holder is considered to be out of the money. Boo. Bummer. Sure, it sucks. But the condition where an investor is out of the money by the expiration date happens all the time. In these situations, investors simply choose not to exercise the option. So this is an easy decision. Lily decides not to take the option and does not buy the shares at the strike price.

If she really wants to buy the shares still, she's better off buying them at $16 a share at the current price. However, she doesn't get her $ bucks back that she paid for that option. Here's the golden rule that we can sum up for this example. With call options, the hope is that you reserve a low price for an awesome stock that ends up skyrocketing in price per share. The best case scenario is that happens, you exercise the options, and you get a discount on a great stock. The worst case scenario is that the market price is lower than the strike price you bought with your option.

In other words, you can buy shares cheaper on the open market than it would cost you to exercise the option. In that case, you do not exercise the option and you lose whatever premium you spent to buy said option. But on the bright side, you didn't sink all of your money into a sinking stock. For today's tip, you can take straight to the bank. Buying options on a brokerage account isn't something you should fumble your way through. If you're interested in buying a call option, you should talk with a representative at your brokerage first and have him or her walk you through your first options order.

As we'll talk about in tomorrow's episode, there are call options that look very similar to options we discussed today, but instead of buying the option, you are selling the option. In other words, you give your option away and commit to buying or selling something at a certain price. The two moves look similar but are dramatically different and could leave you in a devastating position if you mix up the two. So don't try this at home, at least not without your fiduciary. Money Rehab is a production of iHeartRadio. I'm your host, Nicole Lappin. Our producers are Morgan Lavoie and Mike Coscarelli. Executive producers are Nikki Etor and Will Pearson.

Our mascots are Penny and Mimsy. Huge thanks to OG Money Rehab team, Michelle Lanz for her development work, Catherine Law for her production and writing, Magic, and Brandon Dickert for his editing, engineering, and sound design. And as always, thanks to you for finally investing in yourself so that you can get it together and get it all.