Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
- An option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
- People use options for income, to speculate, and to hedge risk.
- Options are known as derivatives because they derive their value from an underlying asset.
- A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
You’ll notice that I didn’t title this article…Stock Trading for Dummies. That’s because Options are different. They are a form of contract on an underlying asset with an expiration date that gives the buyer the right to buy or sell a stock asset. However, there is no ‘obligation’ to do either.
There are other common examples of trading options in life too.
Maybe you saw some land you want to buy, but you won’t have the funds until a couple of months.
Maybe you’ll find a motivated owner and they’ll agree to sell the land to you at an agreed price 2 months from now.
You do not have to buy it in the 2 month period, but you have the ‘option’ to. The landowner does have one obligation…
They must not sell the property during these 2 months in case you want to exercise your option to buy. Nobody else can buy it during that time.
And if the land value doubled, he still must sell it to you at the agreed price. This is a simplified example of trading options.
Stock option agreements function the same way- instead of land, the underlying security is stocks in a traded company. The option contract guarantees the owner will sell the stocks to the buyer at an agreed price (strike price), within an agreed time.
In the case of stock options there is a fee for granting the option. The fee (premium) is a cost to you whether you decide to exercise the option or not. I’ll discuss premiums further below.
Here’s a brief introduction to put options and call options for trade options.
What are ‘Calls’ and ‘Puts’ (simple example)
A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down-payment for a future purchase.
With that knowledge, imagine you have an Apple option for a date 2 months in the future where the strike price is $150…
You have the right to buy an Apple ‘Call Option’ for 100 shares at $150 per share. Or, you have the right to sell an Apple ‘Put Option’ of 100 shares of Apple at $150 per share.
Deciding whether to buy or sell Call Options or Put Options is determined by what you think the market for Apple stocks will do. Will Apple stock be above or below $150 per share on or before the strike date?
If an underlying stock like Apple improves in value it may be is $160 on the strike date. If you have a call option you can buy the Apple stocks at $150 and sell them at $160 for a profit of $10/share x 100 shares = $1,000.
So, if you believe Apple stock will dip to $140 by the strike date, you will place a put option for $150. Then when the strike date arrives you can exercise your right to buy the stocks at the agreed price of $140. You can then sell them at $150 for a profit of $10/share x 100 shares = $1,000.
A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.
The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years.
Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.
With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer.
Let’s say two years have passed, and now the developments are built and zoning has been approved. The home buyer exercises the option and buys the home for $400,000 because that is the contract purchased.
The market value of that home may have doubled to $800,000. But because the down payment locked in a predetermined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s or car insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on their S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, they can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years.
Those who aren’t familiar about how to trade options will often hedge their account using Metals such as gold or silver (safe haven’s); more on that in another blog…
If in six months the market crashes by 20% (500 points on the index), they have made 250 points by being able to sell the index at $2,250 when it is trading at $2,000—a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.
Options do not have to be difficult to understand once you grasp the basic concepts. Options can provide opportunities when used correctly and can be harmful when used incorrectly.
As always, happy trading and stay wild.