Like all investments, options trading can be intimidating for the uninitiated. What are “stock options”? What do I get an option to do? How can having an option, whatever that is, make me rich?
Options may seem intimidating at first – but at the end of the day, they’re just another type of investment. Options contracts give buyers the right, but not the obligation, to buy or sell securities at a set price on or before a set date. Investors use these derivatives (so named because they derive their value from the underlying security) to:
- Diversify their portfolio
- Support their investment income
- Speculate on securities
- Hedge against risk
While these investments carry some enticing benefits, such as the ability to hedge against losses, they also come with significant risks. Investors who seek profits from options contracts must be able to time the market just right – or get very lucky. Plus, some positions carry unlimited losses, whereas “normal” investments are limited to the loss of their account.
What are Options?
Options are another asset class, just like stocks, ETFs, and even commodities are asset classes. While they can be riskier than some investments, such as blue-chip stocks, they also offer advantages that other asset classes can’t.
One way to think about options is as a bet between traders about how a security or asset class will move in the future. These securities are also known as “derivatives” because they derive their value from the underlying asset.
Q.ai says: Other examples of derivatives include futures, forwards, swaps, and mortgage-backed securities. Each of these experiences profits and losses based on price movements of the underlying security.
Options investments comes in the form of options contracts. A call option gives the buyer (or holder) the right, but not the obligation, to buy a security at a set price on or before a set date. On the other hand, a put option gives the holder the right to sell a security.
Typically, stock options represent 100 shares of the underlying stock. However, options contracts can be written on any asset class, including currencies and commodities.
Unlike other “advanced” investments, you can purchase options through a traditional brokerage account. However, most brokers will remind you that options carry a significant risk of financial loss, as they are speculative in nature.
Q.ai says: Options were originally invented for hedging risks and losses against volatile market moves. Investors also use this asset class to draw income, speculate on potential price movements, and diversify their portfolios.
How Do Options Work?
There are four critical components to every options contract:
- The contract is the position of the contract (either a put or a call)
- An asset is the underlying security driving profits and losses
- The expiration date is when the contract expires
- A strike price is the cost of trading the underlying asset on the expiration date
Additionally, there are two parties to every options contract. The buyer, or holder, can choose to either call or put the security of interest. But they are not required to exercise the contract ever, which limits their investment risk.
On the other hand, sellers, or writers, are obligated to exercise the contract if the option expires in-the-money. Because they may have the obligation to move on the contract, sellers are exposed to potentially unlimited risk. Thus, they can lose much more than the initial premium.
Typically, holders take their profits by trading out (closing) their position. In this scenario, a holder sells their position, while the writer buys It back.
Options and Expiration Dates
Traders can accept one of two types of options contracts. Short-term contracts expire in one year or less. Long-term contracts have expiration dates of one year or more. These are legally classified as long-term equity anticipation securities, or LEAPS.
When the expiration date rolls around, if the contract has not been exercised already, there are two ways to resolve the option. A physical settlement involves buying or selling the underlying asset at the set price. While this is uncommon in commodities, it’s more common with stocks and ETFs. However, some traders also take a cash settlement, which involves handing over the value of the assets rather than the securities themselves.
Types of Options Contracts
There are two main types of options: American and European. (Note that this has nothing to do with their geography; rather, they describe how options are exercised).
With an American option, the rights to buy and sell can be exercised anything between the date of purchase and expiration. However, European options may only be exercised nearer to the expiration date.
Thus, many options listed on indexes are European. And, because the right to exercise early carries some value, American options also have higher premiums than European contracts.
Q.ai says: There are several other types of exotic options, such as binary, knock-in and knock-out, Asian, and Bermudan. However, these are usually for professional traders, as they’re more complex than the options we’ve covered.
Buying and Selling Options
Buyers and sellers can make one of four moves on their options: buying calls, selling calls, buying puts, and selling puts.
Just as buying into stock is taking the long position, buying a call option gives you the potential long position in the underlying security. And, as short-selling a stock gives you the short position, selling a naked (or uncovered) call gives you the potential short position in the underlying security.
The opposite is true for put options. When you buy into a put, you are taking a potential short position in the underlying security. On the other hand, selling a naked (or unmarried) put gives you the potential long position in the underlying security.
Example of a Call Option
Let’s say that you want to buy a new car in the future. But, you only want to exercise the right when interest rates go down around the holidays. Imagine, too, that it’s possible to buy a call option from a dealership that allows you to purchase the car at a set price of $20,000, regardless of fluctuations in market price, in the next 12 months.
However, a good dealership won’t agree to hold the vehicle for free – so you put down a $2,000 deposit to hold the vehicle. In terms of options, this $2,000 represents your premium, or the price of purchasing the contract.
Now, back to our car. The holidays come around, interest rates drop within your preferred range, and you exercise your right to buy the car for $20,000. And, even though a shortage of parts has jacked the price of the vehicle up to $30,000 in market value, the dealer has to let the car go for the agreed-upon price.
However, if the holidays come and go and interest rates go up, you have two options. You can buy the vehicle at full price when the contract expires or go to another dealership. Either way, the original dealer gets to keep your $2,000 premium.
Example of a Put Option
Put-options, on the other hand, are more like the full-coverage insurance policy on your new vehicle. This policy protects your investment in the event that something happens to your vehicle.
When you buy car insurance, you pay a monthly premium. This buys you a policy at face value that pays out when, for example, someone rear-ends you at a stoplight.
Put options function in a similar fashion in the stock market.
For instance, let’s say it’s February of 2020, and whispers of a strange, fast-spreading virus hit your news inbox. Let’s also say that this makes you nervous for your $10,000 in Microsoft, and you decide to minimize potential losses to 10%. So, you take out a put option that allows you to sell your position for $9,000 at any point in the next six months.
If, then, March 2020 rolls around and the stock market tanks, you could exercise your right to sell your stocks for $9,000. Then, you can take your money and shove it right back into the market to triple the number of stocks you own at a steep discount. (Note that you’ll still have to pay your premium, regardless of whether or not you exercise your options).
Valuing an option is all about determining the probability of a future price event. The more likely the event is to occur, the more expensive the profiting option position is. Additionally, a longer expiration date leads to a more expensive option, as there is more time for the price to move in your favor.
Volatility also increases the price of your option because the uncertainty means the stock has a higher chance of moving in your favor. As a rule, as the volatility of the underlying asset increases, the more likely a swing will move the security substantially closer to your speculated goal. Therefore, greater market volatility leads to more expensive options contracts. In this way, options trading and volatility are inherently linked.
Advantages and Risks of Options Trading
Like all securities, options contracts come with their own advantages and risks. Whether or not they’re a good investment for you depends on your goals, financial situation, and investment time horizon, among other factors.
Options Trading Advantages
- Requires smaller initial investment than purchasing securities outright
- Limits exposure to risk on current stock positions
- Protects investors by locking in prices at no obligation
- Provides the investor time to watch the market move
- Options trading investors must be approved through a broker, and trades are limited to your assigned trading level
- It’s difficult to accurately predict even short-term price movements with options trading
- Investors may take on unlimited losses with options trading
- Margin requirements can lead to higher trading costs with options trading