Taking the Mystery out of Options
Welcome to the world of investing and trading with options. The purpose of this article I have written is to show you what options are, how they work and when they might be used to enhance your investment activities. Options can add value to what you are already doing whether you are an investor or trader, conservative or aggressive, looking for income or looking for capital gains.
Like many people new to options, you may be feeling a little nervousness. In some circles the word “options” conveys the notions of high risk. While it is true that options can be used to speculate, the same can be said for any investment product. Options were invented as a tool to manage risk, so options can be used in a variety of ways from conservative to aggressive.
Regardless of your investing goals, risk tolerance, or experience, be aware of two keys to using options. Firstly, gaining an understanding of their unique properties and secondly, adapting to the different thinking process that using options requires. Put simply, investing or trading with options is different than investing or trading with stocks. Because options have an expiration date, you have to have a plan in place.
This article will introduce you to the fundamentals of options. Keep in mind that most options traders have many years of experience, so don't expect to be an expert immediately after reading this information.
Options are just Insurance Contracts
I’ve read quite a few books on options and the simplest analogy I’ve found is that options are very much like insurance policies. So if you have ever bought insurance for your car, home or even life then you have used options already.
Still confused? Let’s go through a couple of practical examples to hopefully clarify things. We should start to think about how about how insurance policies work.
Imagine you are lucky enough to buy a brand new car. One of the first things you do is call up the insurance company and take out some car insurance. You pay a premium to the insurance company and for that the insurance company gives you an insurance policy for a year.
Now usually only two things can happen in that year.
1) Your car is damaged or stolen – in this instance you have an insurance policy which has increased in value – you then use this policy to regain the value of the car.
2) Nothing happens – the insurance company keeps that premium.
In this example the insurance policy or “option” purchased was used to protect the value of your new car
Now think about your own share portfolio. Can you think of an occasion where you would like to protect its value?
Here’s a second example, Imagine that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another six months. You talk to the owner and leave a security deposit so that you have the option to buy the property in six months for a price of say $500,000.
Now, consider two theoretical situations that could happen in the next six months.
1) You discover that the land the house is on contains huge amounts of gold. As a result, the market value of the property multiplies. Because you have left a deposit and have a contract with the owner, he is obligated to sell you the property for $500,000 – leaving you with a substantial profit.
2) Upon closer inspection of the property, you find out that the house next door is occupied by a gang of criminals. Though you originally thought you had found the house of your dreams, you won’t even consider moving in. On the upside, because you left a deposit for the option to buy, you are under no obligation to go through with the sale. Of course, you lose the deposit.
So in this second example the security deposit or “option” was used to insure the purchase price of the house.
Now think about some shares you want to buy. Is there a share that you would like to buy at a certain price but don’t have all the cash available?
Two Types of Options
So now that we can see that in the real world options are just like insurance policies or security deposits it’s time to have a look at options as they are used in the stock market.
Now in the world of options there are only two types, namely CALL options and PUT options.
- Call options are like security deposits which increase in value if price rises.
- Put options are like insurance policies which increase in value if price falls.
So in our two examples the car insurance policy is actually a PUT option and the security deposit on the house example is actually a CALL option.
So with that explanation behind us we can now go to the definition of options which most financial books will start with:
An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
Options vs. Stocks
In order for you to better understand the benefits of trading options, it’s helpful to understand some of the similarities and differences between options and stocks
Similarities
- Listed Options are securities, just like stocks
- Options– trade like stocks, buyers make bids and sellers make offers
- Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security
Differences
- Options are derivatives unlike stocks i.e. options derive their value from something else – the underlying security
- Options have expiration dates, while stocks do not
- There isn’t a fixed number of options as there are with shares available
- Shareholders have a share of the company, with voting and dividend rights. Options convey no such rights
Why Use Options?
There are two main reasons why an investor would use options: to speculate and to hedge.
Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways. So why do people speculate with options? Aside from versatility, it's all about using leverage. When you are controlling 1000 shares with one contract, it doesn't take much of a price move to generate good returns.
Hedging
The other main use of options is for hedging purposes. Just as we have discussed in the examples nearly everyone insures their house or car. Options can be used to insure your investments against a downturn. Conversely they can also be used to insure against an increase in price. An example of this would be an airline that would insure against a rise in the price of crude oil or a bakery insuring against a rise in the price of wheat.
You can buy and sell options!
Most people only ever think of buying options – well the great thing about options is that you can be a buyer OR seller.
There are four types of participants in options markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called writers. Also buyers are said to have long positions, and sellers are said to have short positions.
Here is the important distinction between buyers and sellers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. So if you buy a call option and the stock does not rise then you don’t have an obligation to pay the higher price.
- Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. In other words if you have sold a call option and the stock is higher at expiry, you have an obligation to sell at the price agreed.
So if you have a view on a share there are multiple ways to profit using options. If you think a stock is going to rise, you can buy a call OR sell a put. Now if you think a stock is going to fall then you can buy a put OR sell a call.
The reason why I have mentioned these facts in this introduction is to get you thinking about trading in general and thinking about both sides of each trade. Remember that for every time someone buys an option, someone else is selling. If you think buying options is risky then why not take the other side to the trade? Have a think about how large insurance companies make money selling insurance policies or selling PUTS – are they doing something risky? Just some food for thought!
Recap
So let’s go over the main points in this article.
- An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.
- Options are derivatives because they derive their value from an underlying asset.
- A call gives the holder the right to buy an asset at a certain price within a specific period of time. A put gives the holder the right to sell an asset at a certain price within a specific period of time.
- There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
- Buyers are often referred to as holders and sellers are also referred to as writers.
- Investors use options both to speculate and hedge risk.
Conclusion
I hope this article has given you some insight into the world of options. Once again, I must emphasize that options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. My main aim in writing this article was to get you thinking about options used in everyday life and how they are used in the stock market. Please use this article as it was intended - as a starting point to learning more about options.