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In previous articles, we discussed two types of stock options: calls and puts. The call was used to profit from an upward movement in stock price and the put was used to profit from a downward movement in stock price. Each can be used for hedging purposes or speculative purposes. The greatest challenge in using stock options often stems from determining their valuation. Stock options, in essence, are contracts based on possible outcomes. Given the level of uncertainty associated with them, assigning value based on numerous possible outcomes can be difficult to say the least. Thank goodness for Wall Street quant jocks.

Options have been around for almost as long as trading markets (ancient Greeks and Romans used various forms of options to hedge cargo values). As a result, various methodologies to determine the value of these options evolved. Today, the most widely used method is the Black-Scholes model. This model can be simple to use but difficult to understand. It’s based on a complex algorithm that incorporates the following variables: the current stock price, the strike/exercise price of the option, the risk-free interest rate, the time until maturity and the historic volatility of the stock. In certain instances, other variables such as dividend rates may be used as well. If the information is available, using the Black-Scholes model is simply a matter of plugging numbers into a complex equation which is usually built into a spreadsheet. The result is a number representing the value of the option. However, understanding the equation and the effect the individual inputs have on it is something on which few seem to have a firm grasp.

Nowadays, analysts and traders will gladly use the Black-Scholes model but the overriding complexity of it can deter most from challenging it. As a result, the financial markets are sometimes forced to accept it on blind faith, which can prove troubling during times of financial uncertainty.

Learn more about these and other useful concepts at our many upcoming webinars, local seminars, and on-demand programs.

In a recent article, we discussed the structure of what’s known as the call option. As we discussed, call options are essentially contracts to purchase a certain number of shares of a stock at a certain price, within a certain amount of time. When the price of the stock increases, the value of the call option generally increases as well. We saw that the advantage of holding a call option is that it allows you to capture the upside of a stock’s upward movement with less capital and minimal downside. So what if we believe that a company’s stock price is going down? How can we protect ourselves or, profit from this downward movement? We buy a put option. Put options, like call options, are contracts that allow the holder to profit from the movement in an underlying stock (or other security).

Let’s imagine that our favorite company, Bailout Industries, has fallen on hard times. Its stock is trading at $10/share and you believe it could drop to as low as $5/share in the next year. You currently own 100 shares of Bailout stock and are concerned that if you hold on to it, you could lose half your investment. In order to protect this position, you buy put options. The December 2010 $10 put option is currently selling for $2. In other words, a contract to sell one share of stock at $10 before December of 2010 is priced at $2. If the stock drops to $5, your put option will appreciate in value. At expiration, it will be worth $5 (the $10 you would sell it for minus the market price at that time). So while you lost value on the stock position, you gained value on the put option position. The put option was essentially an insurance policy against a drop in stock price.

The problem with put options is that if the stock price stays flat over the next year, you would lose the $2 premium that you paid for the option. In other words, you had to pay the equivalent of 20 percent of your position just to protect it! For some, giving up something to have this kind of protection is well worth it. Of course, to break even, their stock will now have to appreciate by 20 percent.

Learn more about these and other useful concepts at our many upcoming webinars, local seminars, and on-demand programs.