I trade a lot of options. “Aren’t options risky?” Yes, they can be, but they can also be bought or sold to hedge risk if you know what you are doing. Don’t trade options by yourself if you have never done so before. Remember when you learned to drive a car? You needed a parent or (preferably) a professional instructor to teach you the basics. You (hopefully) drove slowly at first, then sped up as you gained confidence. You really learned to drive once you got your license and drove solo. So it is with options trading. Learn from a professional and go slow at first before striking out on your own.
Derivatives is another word that has become pejorative in some circles because derivatives trading has sunk a few investors and even financial institutions. Options are a derivative security. All that means is that options have no value in and of themselves; rather, their value “derives” from the company or the index they are associated with. An option to buy 100 shares of Apple Inc. is not worth anything unless there is an Apple Inc. stock.
There are two basic types of options. A Call option gives the owner the right (but not the obligation) to purchase the underlying security at a specific price within a specific time frame starting when the purchase is made until the maturity date of the option. The specific price is called the Strike Price. Options cost money, and the price of the option is called the Premium. The size of the Premium (i.e., the cost of the option) is a function of several factors, including:
1) The current price of the stock;
2) The strike price of the option;
3) Time until the option matures; and
4) The volatility of the underlying stock.
There is an academic equation called the Black-Scholes Option Pricing Model that attempts to determine what the textbook price of an option is. This will be the subject of a future blog post and not important for this post.
Options are sold in Contracts. One Call option contract typically gives the owner to purchase 100 shares of the underlying stock. Depending on the size of the underlying company, call options are offered at various strike prices and various maturities, usually ranging from one week to one year out. The bigger the company, the greater number of strike prices and the greater number of expiration dates. Index ETF’s can have options as well as can individual stocks. For instance, one of the most actively-traded ETF’s is the S&P 500 Index ETF (the SPY). The SPY has strike prices for every $0.50 of the value of the SPY ETF (closing price today: $243.76), and maturity dates of every week for the next several months, and monthly maturities thereafter. There are many options opportunities and investing strategies for options available in the marketplace.
Owning a Call option is a “bullish” investment strategy. The Call owner thinks the underlying stock is going to go up. The value of their Call will rise if the stock goes up. A Call option is “in the money” if the option’s strike price is below the market price of the underlying stock. “In the money” because the owner could use the option to buy the stock at the strike price, and then right after sell the stock they just bought in the market and collect the profit.
The opposite of a Call, a Put option gives the owner of the Put the right (but not the obligation) to sell the underlying security at a specific price within a specific time frame starting now until the maturity date of the Put option. You can easily see how owning a Put is a “bearish” strategy – the value of the Put will increase if the underlying stock goes down. You can also easily see that owning a Put can be a great hedge if you also own the underlying stock. Most Puts are purchased to hedge long stock positions. If you own 100 shares of a stock and the stock goes up but you are worried it might go down but you don’t want to sell the stock yet, then you buy a Put. That way, you lock in your profits at the Strike Price of the Put. A Put option is “in the money” if the market price of the underlying stock is below the Strike price of the option.
But Not The Obligation
Most option owners don’t ever actually exercise their options to buy or sell their stocks, even if the options are in the money. Instead, they will sell their option through the options marketplace (same place they bought it in the first place). If they are in the money, they will realize their profits via the sale of the option rather than the underlying stock. Who does ultimately exercise these options? Somebody out there. Probably not you.
This blog post is Basic Options 101, or even before that. You will learn and get comfortable with Options as you gain more experience with them. Don’t bet the farm initially. Start slowly until you are comfortable driving solo. Don’t ever speed – a speeding ticket can cost you a lot of money. Work with a professional (another shameless plug for you to contact me!).