Options are a relatively complex investment that even seasoned investors make a point to steer clear from. Despite options’ notorious reputation for complexity and risk, they are simple in nature and best understood by examples (I will be using many examples to explain options in this article).
So, what are Options?
They are a financial agreement between a buyer and a seller for an asset price at a future date. Options are considered derivatives as they represent underlying assets and are mostly used to trade stocks and commodities. They are cleverly called options because the buyer has the option of redeeming the agreement or abandoning the agreement depending on the value of the asset. The technical explanation of an option is often termed “right, but not obligation”—meaning if the buyer wants the asset, it is his, but if he does not, he can abandon it.
At this point many of you are probably thinking, “Wow, how can you lose with such an easy investment? Even worse, what in the heck is the seller thinking by cutting this deal?” As with any investment, there are stipulations that make this not such a walk in the park. Fundamentally, the buyer is getting the best of both worlds with an option, so what is the seller getting? The seller gets a premium the buyer must pay in order to receive the transaction. If you invest $1,000 in an option over the course of 1 or 2 months, the seller could be taking a premium of $250 just for giving you the option.
In a vacuum in the long run (and absent of the premium), option holders will always win because of having choice. But with a premium for the investment much of the average gain is taken away and given to the seller. Thus they become more of a fair deal for both buyers and sellers. Now the true game of option investing is exposed.
Now that we have tasted the theoretical side of options lets bite into how they really work.
When one wants to purchase or sell an option, they agree to a set month, premium price, and asset price. The date is always the third Friday of the month. The premium price and asset price are always some calculation of the future risk and rewards.
Let’s say in October Jim thinks Apple is going to go up and buys an Apple (AAPL) option when apple’s stock value is at $85 and the option premium is $4 per share. Jim purchases a 2 month option to say $95. Jim’s option will commonly look like “November 95”. The option Jim bought has 100 shares. Jim’s 100 shares cost him a premium of $4/share so he spent $400 for the option.
One month has gone by and Jim’s bet that Apple would go up has not worked out well so far. The stock has remained relatively flat and is at $87. Jim’s option is still useless; he is losing the bet so far. A month later Apple released the I-pad and the value of Apple’s stock skyrockets to $101. At this point Jim’s premium has raised with the value of the stock. Jim’s premium now is $10/share.
Here are his calculations so far:
(PremiumNOW*100)-(PremiumPURCHASE*100=Profit —> ($10*100)-($4*100)=$600
Jim cannot let his option expire or his investment is useless. He must do one of two things:
- 1. Sell the option back to the writer for a $600 dollar profit
- 2. Buy the stocks at the original option strike price of $95 and sell them for $101 and make a $600 dollar profit.
*These numbers have been simplified to explain the concept. In reality the premium price would fluctuate that so option #1 & #2 do not have the exact same profit.
Jim just successfully executed a call, but let’s nail down a concise definition of a call.
What are Option Calls
There are two types of options, one of them is a call. A call is the buyer side of an option. In our example above Jim profited from the call.
What are Option Puts
Puts are the opposite of a call. Writers issue puts often to hedge risk for their companies. If Apple’s new I-pad was a huge flop and the stock dove, Apple would be covered by Jim’s investment loss! Puts are simply the other side of the coin for calls.
There are four major player groups in the options world.
- 1. Call sellers
- 2. Call Buyers
- 3. Put Sellers
- 4. Put Buyers
The strike price is when a particular option can be exercised. From the example above, Jim’s strike price was $95. However few options get exercised. According to the CBOE, 10% of options get exercised, 60% get traded on the markets, and 10% expire worthless.
There are three types of options. The style of option will be noted in the issuing of the option. These styles also affect the value of the option as they limit or increase choices.
- American option – Can be exercised at any time. This is the most valuable option style to have as it has the most options.
- European option – Can only be exercised at the expiration date. This is the cheapest style of option to have as it has the most restrictions.
- Bermuda option – Can only be exercised periodically. These are typically used in assets that rely heavily on interest rates.
- Barrier option – Can only be exercised if the asset value has passed a certain price.
While options can be considered risky and complex, they are safe in the right hands. Companies often use options to hedge risks. Strategies have been developed to guard against fast value changes. If used correctly, options severely reduce risk to stock valuation and are a perfect tool to have in any investor’s toolkit.
Many innovative strategies have been developed over the years involving options. The very popular Cover Call strategy is where an investor simultaneously buys a stock and sells a call. This strategy offsets losses and fixes wins, essentially covering for risk on both ends. The Iron Condor, Straddle, and Strangle are also other popular strategies.
Conclusion and Forewarnings
Options are truly a fascinating investment tool. From calls to puts, there are many ways to create a winning strategy. Great investors always have a playbook full of plays, and options are not a bad one to keep around. Some of these option plays can express amazing leverage in the right situation. Among the more interesting things is the combination of strategies. I mentioned the combinations under the “Other Information” heading.
However unlike other investments, option investing is a tool that takes the utmost dedication and skill. “What are Options” represents a mere drop in the bucket for the information available on option investing. These investments are not for the faint of heart. Anything less than a few dozen hours of investing studying is simply inadequate for this style of investing—and with more hours there are still no guarantees. Good luck and do not be afraid to let these options be handled or supervised by professionals.