What is an Option?

Options are very complicated financial instruments that can be used in a portfolio in many different ways. Options are not for everyone, but when used by an educated investor they can actually reduce risk in your portfolio. Before using options you must understand how they work, what the risks are, and the different strategies that can be used.

An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a certain price during a specified time frame. During this time frame, the buyer of the option has the right, but not the obligation, to buy or sell the asset, while the seller has the obligation to fulfill the transaction if requested by the buyer. The price of an option is derived from the value of the underlying asset (most commonly a stock) plus a premium.   Simply put, it is a contract that allows you to buy or sell a stock at a predetermined price within a set time frame.

Option Characteristics

• Type of Option:

o   Call Option – conveys the right to buy the stock

o   Put Option – conveys the right to sell the stock

• Strike Price – also called the exercise price, is the specified price the stock may be bought or sold
• Expiration Date – is the specified time frame or life of the contract
• Each option contract represents 100 shares of the stock (leverage)
• Amount paid for option is called the premium

Call Options

Buying a Call Option (Bullish)

Image via Wikipedia

An investor will typically buy a call option when they believe that the price of the stock will go above the call’s strike price, before the call expires. The investor pays a premium for the right to purchase the stock at the strike price. Typically, if the price of the underlying stock has surpassed the strike price, the buyer pays the strike price to purchase the underlying stock, and then sells the stock and pockets the profit. Of course, the investor can also hold onto the underlying stock, if he or she feels it will continue to climb even higher.

Example 1

One way to think of this in everyday life is by relating it to a house you would like to buy in a certain neighborhood.  Today a house that you like is on the market for $200,000 and you don’t know if it is a good time to buy because you’re worried that home prices may continue to go down.  At the same time, you love the house but would hate to pay more than $200,000 if prices go up. Instead of buying it today, you and the seller agree that for a $5,000 fee he will sell you the house in three months for $200,000.  The seller is now obligated to sell you the house at $200,000 and you have the right to buy the house in three months for $200,000.

Scenario 1

After three months the housing market declines and the average house in the neighborhood is now $150,000.  You decide not to buy the house since you can look around and find one at a cheaper price.  You only lose the $5,000 fee you paid the seller. If you had bought the house outright, you would have lost $50,000.

Scenario 2

After three months the housing market improves and the average price in the neighborhood is now $250,000.  You decide to buy the house for $200,000 because if you didn’t you would have to pay $250,000 to buy another house in the neighborhood. Your total cost is $205,000 ($200,000 plus the $5,000 you paid for the option).  Your gain on the house would be $45,000 ($250,000 minus $205,000). If you had bought the house outright, you would have gained $50,000, but you only had to risk $5,000 of your money, rather than $200,000.

Example 2

Now that I’ve walked you through the housing example I want to put it back into stock terms. Let’s say you are interested in a stock and after all your hard work researching it you conclude that it will increase in value over the next couple of months, but you are concerned that there is still a reasonable chance the stock will go down.  There are two ways you can act on your bullish sentiment.

Buy the Stock

One way to do this is to purchase 100 shares of stock at $20 for a cost of $2,000. If the stock rises from $20 to $25 you would have a $500 gain or a 25% increase in value.  If the stock goes down to $15 you would have a $500 loss or a 25% decrease in value.

Buy a Call Option

An alternate way to do this is to control 100 shares of stock by purchasing an option with a strike price of $20 at a premium of $2 per share for a cost of $200 (1 contract x 100 shares x $2 premium = $200). If the stock price at expiration is $25 the option premium would rise from $2 to $5, the original cost was $200 and it is now worth $500. You have a $300 profit, but a 150% return.  If the price of the stock were below $20 you would lose all of your $200 or 100% of your investment.

Don’t get too caught up on the calculations here, the key point in using call options is that it limits your risk by reducing the amount of capital needed, but because of the leverage, it leaves open the potential for higher gains.

In my next posts I will talk about using covered calls to generate income in a portfolio and buying puts to protect your portfolio from volatile downward movements.

Marcus Green