Options scare a lot of people. Everyone gets hung up on the risks associated with adding options into their portfolio. What it comes down to is this- most people don’t really know what options are in their most basic sense. Let’s be honest, why else would you be reading a post explaining what options are?
It’s because you don’t know enough about options. Don’t worry, by the end of this post, you will know the core concepts of options.
Ideas mentioned in this post:
- Options are contracts
- What are call options?
- What are put options?
- Benefits of using options
- Options actually minimize risk
- Options offer higher returns
- Smaller capital requirement
- Options give you options
Options Are Contracts
An option is a trade-able contract. Buying an option gives you the right to buy or sell 100 shares (per option that you buy) of the underlying security at a specific price. The price of the option is what you pay in order to own the contract.
Here are the three main components of an option:
Premium
What you pay for an option is known as the premium. For example, let’s say you want to purchase an option that is trading for a premium of 1.35. Since an option is a contract that represents 100 shares of the underlying security, you figure out how much you need to pay by multiplying the premium by 100.
The equation would look like this:
Premium x 100 x number of option contracts purchased = total paid
Using our example, the amount paid in premium would be $135 (1.35 x 100 x 1).
The premium of an option is calculated by many different factors such as volatility, days until expiration, and relation to the price of the underlying.
Strike
The strike of the option represents the price the buyer of the contract will buy or sell shares. It is important to note that an option can only be exercised once the underlying passes the strike price.
For example, let’s say you are taking a bullish stance and buying an option with a strike of 35. You may only exercise that option and buy 100 shares of the underlying for 35 per share once the underlying is above 35.
The opposite is true if you are taking a bearish stance.
Money-ness
Money-ness is a term that is used to refer to the status of your option in relation to the underlying.
An out-of-the-money (OTM) option is when the underlying has not yet passed the strike and is still far away from doing so. The premium of OTM options are usually small. If an option expires out of the money, you cannot exercise it and it will expire worthless.
An at-the-money (ATM) option is when the underlying has not yet passed the strike, but it is not too far away from doing so. The premium of ATM options are usually much higher than OTM options.
An in-the-money (ITM) option is when the underlying has passed the strike. The premium of the ITM option is the highest and usually gains value at a similar rate to the underlying.
What Are Call Options?
Calls are an option that give the buyer the right to buy 100 shares of the underlying. You should buy calls when you have a bullish outlook on the underlying.
When you are looking to buy a call, the strike you choose should be based on where you think the underlying will be by the time it expires.
*Only purchase a call option with a strike you believe the underlying will be above by expiration*
If the underlying is below the strike of the call option at expiration, you will not be allowed to exercise it and it will expire worthless.
What Are Put Options?
Puts are an option that give the buyer the right to sell 100 shares of the underlying. You should buy puts when you have a bearish outlook on the underlying.
When you are looking to buy a put, the strike you choose should be based on where you think the underlying will be by the time it expires.
*Only purchase a put option with a strike you believe the underlying will be below by expiration*
If the underlying is above the strike of the put option at expiration, you will not be allowed to exercise it and it will expire worthless.
Benefits Of Using Options
Now that you know the basic principles of options, let’s discuss the benefits of using them.
Options are not just a substitute for owning stocks outright. Rather, options let you minimize risk, leverage your portfolio for higher returns, and they can be manipulated into complex strategies for any market situation.
Options Actually Minimize Risk
Contrary to popular belief, options let you minimize your risk. That’s right! Everyone who goes around saying options are super risky are wrong and probably don’t know what they are doing.
Let me explain.
Remember when we were discussing options expiring worthless if the underlying is not past the strike? Tell me, how much do you think you would lose if the option expires worthless….
Exactly…. you can only lose whatever you paid for the premium. In the case of the one option selling for a premium of 1.35, your max loss is a whopping $135!
That’s a smaller max loss than if you owned 100 shares of the underlying. When you own 100 shares of the underlying, your max loss is whatever it costs to own 100 shares. So if the underlying is 35 per share, your total investment is $3,500. That would give you a max loss of $3,500!
So why do so many people think that options are so risky?
The answer is that they don’t know the basics of options and how they work. People experience huge losses trading options because they buy too many contracts not knowing that each contract represents 100 shares. The other issue is that they choose the wrong strike and the wrong expiration for their options.
Options Offer Higher Returns
The magic of options is that they can reward the buyer with huge returns. The profit potential is what attracts so many people.
Options can offer higher returns than owning the underlying outright. This is especially true if you sell the option before expiration instead of exercising it.
The premium of options increase when the underlying gets closer to being in-the-money. Once an option goes past the strike price, and goes in-the-money, the option usually gains 1.00 in premium for every 1.00 the underlying moves past the strike.
If this happens, especially way before expiration, you would want to consider selling the option and pocketing the premium received from the sale.
Let’s say you buy a 35 strike call for next year for 10.00 in premium. Next week the underlying has some good news and zooms past 35 to 45. Your option is now trading at 20.00. If you sell it, you receive $2,000 in premium. Since you paid $1,000 in premium, you just made a profit of $1,000 in a week.
That’s a 100% return on your investment in just a week!
Smaller Capital Requirements
Options let you leverage your portfolio in a way that will make you never want to buy shares on margin ever again.
If you are speculative on a security and don’t have enough cash available to buy 100 shares of the underlying, why not use an option to control 100 shares? Using the previous example of a stock trading at 35, you could buy 100 shares for $3,500 or you could buy the right to own 100 shares for a premium of $135.
I would go with the option for three reasons:
- Avoid paying interest on the margin used to purchase the shares.
- Limit my losses in the case that I am wrong (also would allow me to avoid a margin call).
- Use any additional cash to buy another option.
Options let those with a smaller portfolio get exposure to more stocks than they would if they bought shares of stock. It also allows those with small portfolios to trade stocks that are expensive. You could essentially trade 100 shares of a 3000 stock like AMZN for as low as $1,000.
That’s $299,000 cheaper!
Options Give You Options
Options are the most flexible investment instruments out there. You can invest and trade options in so many different ways. There are many complex and advanced strategies that can be used.
You could use options as a hedge to current positions that you have in your portfolio. Or, as strange as it sounds, you can use options to hedge your current options positions.
Yup! You can hedge an option with an option.
Such strategies aren’t exactly known as hedges and they have fancy names. They are created by buying/selling different options to increase the probability of a profitable trade.
For example, one strategy known as a “strangle” consists of buying both a call and a put at the same time for the same expiration. What other investment instrument lets you take a bullish and a bearish position at the same time?
Of course there are many other factors that go into determining which strategy is suitable for a given situation, but the point is that options give you options.
Options are Optional
At the end of the day, your use of options is entirely up to you and your risk tolerance. Options can let you leverage your portfolio, increase returns, and minimize risk. Those are only possible if you study options and learn how they work properly.
Being an options trader can benefit you tremendously. Take the time and study all of the different options strategies that are out there!
Did you enjoy this post? Is there anything I forgot to mention? What’s your opinion on options trading? Make sure to let me know!