What Are Options?
Options are a contract which provides the opportunity to buy or sell an asset at a specific price at a specific future time. Options are part of a broader class of financial instruments known as derivatives, which gets their name from the value of the instrument deriving its value from the value of the underlying asset that it is based upon.
So if you buy an option, this gives you the right to buy or sell short a certain asset, like a stock, an index, or even a futures contract, and futures are another type of derivative, so in this case this would indeed be a derivative contract trading in a derivative, both being based upon the value of the underlying commodity.
Options are used both for hedging and for speculation purposes. In the case of hedging, one would be in a position such that a certain outcome would want to be hedged against, causing the asset to decline in value. This can be directly or indirectly.
An example of direct losses would be a position that you have with the underlying asset itself, a long position in a stock for instance that you want to limit your potential losses with over a given period of time. You could buy options to limit your losses here, as in insurance policy.
Indirect hedging benefits involve buying or selling options with assets that could influence the results of other assets. An example would be holding assets in a different currency and buying an option on that currency so that if the currency loses value, you would make money from the option and offset these losses to some degree.
Many people use options to speculate as well, for the same reasons that they may speculate in the assets directly, where they expect a certain movement in the price of an asset over a given timeframe. Options trading always involves fairly short term speculation, but they have the benefit of allowing for much more leverage, buying or selling much larger amounts than you would be able to if you bought or sold the assets directly, although this also introduces much more risk as well.
Options trading always involves a special risk disclosure to make investors aware of the higher risk involved, and it isn’t that uncommon to lose the entire investment should the trade not work out. You can also make a lot of money from trading options as well, so provided that one can afford to take additional risks with the options contracts one buys, or if one is using them for hedging purposes, options can be quite attractive.
Buying Call Options
There are two types of options buying, the long side called calls and the short side called puts. Buying a call is pretty straightforward, you are paying a certain amount of money for the right to buy something, the asset, a stock for instance, at a certain price upon the expiration of the contract, called the expiration date.
The price that is specified in the contract is called the strike price. So for example let’s say you buy a call option on XYZ stock which is currently trading at $50 a share, and you buy a single contract which consists of the right to buy 100 shares.
You will pay a price for the contract, called the premium, which is based upon the current position of the stock as well as the market’s outlook as to where it is expected to go during the life of the contract. So if the strike price on the option is $55, you will be placing a bet essentially on it going over that amount, and the premium will reflect the estimated odds of that happening, based upon the current belief in the market.
If the price of the stock does not exceed the strike price at expiry, the option finishes out of the money and ends up being worthless, and this is one case where the option holder would lose their entire investment, the money they paid for the premium.
Options do not need to be held to expiry though, and may be traded at any time during the life of the options contract, sold to another investor who then picks up the ball and holds it for a while, up to the expiration date. The price of options moves up and down depending on what the expectation is on its value at the expiration date.
Buying Put Options
If you expect the stock to go down in price and you wish to place a bet on that side of things, you can buy a put option, the right to sell short the stock for a specified price at a specified time. With put options, if the strike price of the option is below the price of the underlying asset at expiration date, then a profit can be realized by selling the stock short.
Investors can take long positions in an asset, where the expectation is that it will increase in value over a certain amount of time, or in many cases they can sell the asset short, borrowing the asset from a broker and selling it, and agreeing to buy it back later, hopefully at a lower price should it decline in value as expected.
Another way to speculate on expected declines besides shorting the asset itself is to buy a put option, where instead of having the option to buy it at a certain price at a certain point in time like a call option gives you, a put option gives you the option to sell the asset short at a given point in the future for a given price.
So while call options bet on something going up, put options bet on their going down. In both cases, one’s risk exposure is limited to the loss of the premium paid for the option, whereas if you just sold the asset short you could be exposed to a lot more risk depending on the situation.
In our example, XYZ is trading at $50 a share and we might buy a put option at $47 a share for example, and the further below $47 it trades at the expiry date, the more money we can make from the option, although if it doesn’t go below that, the option will expire worthless.
Buying put options also has the advantage over normal short selling of not having to follow exchange rules such as only selling short on an uptick, or other restrictions that may come into place at various times. Put options are simply traded at will between traders, and can be bought and sold anytime one wishes.
So with both types, call options and put options, both risks and return rates are magnified over trading the underlying assets, and therefore it’s even more important to be correct than normal. Skill and foresight are therefore at an even bigger premium, but the greater one’s skills and foresight is, the more they can leverage this through buying options.
While options are generally traded between options traders, someone has to write the options so to speak, bearing the risk on the other side of the trade. For instance if you buy a call option for XYZ stock, and you make a profit on it, someone has to take the other side of the trade. You generally would have bought the option from another trader, so it’s not them, they bought it too, but who sold it originally?
This is where the options writer comes in, the person who will be selling you the stock at the stock price. Let’s say you exercise the option for $60, and make a profit of $5 per share on your call option. The option writer would be the one selling you the stock for the strike price of $55, where you would sell it on the market for the $60 and realize the $5 per share profit.
The options writer, had they not gotten into this contract with you, could have kept the stock if they held it during all this time, and made the profit from the price increase themselves, and they did get the premium from you, which they keep if the option expires out of the money, but they have to bear the responsibility of the profit on the other side if it doesn’t.
The options writer also only receives the original premium for the contract, much like companies only receive the initial purchase price for a stock, and wherever it ends up trading from there is money that is made or lost on the price movement by the options traders themselves.
Options writers may take positions on the other side of their trades to limit their losses, and their potential losses aren’t capped by the cost of the premiums, they are exposed the same way that a short seller of a stock would be, and the more it moves against them, the more they stand to lose, up to huge amounts.
Often times options writers will own the underlying security, but not always, and when they don’t, this is called naked option writing, and is even more risker than normal options writing. In this case, should the deal go sour for them, they would have to obtain the stock on the market at expiration, at a time after the price has moved against them, and their losses are all out of pocket now instead of perhaps only sacrificing profits they would have made for themselves had they not written the option.
Some individual investors dabble in options writing, but generally only larger investors perform this function, and there’s plenty of money to be made by buying options contracts anyway so there’s no real need for smaller investors to want to get involved in writing, although having an idea of how this all works doesn’t hurt.
Options can be a great way to hedge positions and also add some real spice to an individual investment plan provided one exercises enough care with them and always limits their potential losses to what they are comfortable with.