What is an Option?
Most investors are looking for a way to either increase their returns or reduce their risk. Though options have the ability to do both these things, many people don’t understand what options are or how to use them. They also think that options are too difficult and complex to learn, though once learned, the endless supply of options combinations tends to be a blessing, not a curse. People who don’t understand options are missing out on the many strategies that can enhance returns and lessen risk.
But what is an option? In the most technical definition, an option is the right but not the obligation to purchase or sell shares of stock at a predetermined price, by a prearranged date. The predetermined price is known as the strike price, and is chosen by the options trader when he/she enters a position. The prearranged date is known as the expiration date. Depending on which direction you think the underlying stock will go in, there exist options strategies to take advantage of that stock price movement.
If one believes that a stock is going to go up, one can buy a call. A call is an option that gives the purchaser the ability to purchase stock at the strike price and the expiration date in exchange for a premium. If the market price is above the strike price, the purchaser of the option can profit by exercising it (buying the stock at the strike price) and selling the shares at the open market price. Since the premium tends to be quite small compared with the cost of purchasing the stock, this can add substantial leverage to one’s position to take advantage of a short-term gain in the share price. If the stock is below the price of the strike, the option is not exercised, as it would be cheaper to purchase the stock in the open market. The only loss in this scenario is the premium.
If one believes that a stock is going to go down, one can buy a put. A put is an option that gives the purchaser the ability to sell stock at the strike price at the expiration date in exchange for a premium. If the market price is below the strike price, the purchaser of the option can profit by selling the option seller shares of a corporation and repurchasing them at a lower cost in the open market. Compared to shorting stock where losses can be immense, one can only lose the premium.
Most options are standardized with predetermined dates and prices. Most options in the United States are based upon an increment of 100 shares, which is also known as a “round lot” which helps to standardize the contracts. The expiration date tends to be standardized to occur on the third Saturday of the month, though on some bigger companies, weekly options may exist. At any given point, many contracts are traded at different strikes and expiration dates, making the universe of possible options quite vast.
For an example, we will look at options at a hypothetical XYZ Corp. A share of XYZ Corp. costs $50 at the open market price. If you believe that the underlying stock is going to be at $55 in two months, you could purchase the 100 shares at the market price for $5,000. However, the price of a $50 strike call option may be $2.00. So the total cost of one option for 100 shares would be $200. If the stock rises to $55 in two months, you would make $500 (100 shares * $5.00 per share) on the stock purchase, and you would make $300 on the options trade (100 shares * ($5.00 per share gain - $2.00 per share cost)). The amount of risk you took for that $500 on the stock trade is $5,000 while the options trade risked $200 to make $300. In this scenario the stock trade made 10% while the options trade made 150%. That said, had the stock gone down to $45, the stock trade would have lost $500, while the option trade would have lost $200.
Why do people trade options? Options can allow you to better hedge the amount of risk in your portfolio. If you strongly believe that a company is going to be at a much higher price in the future you can adjust your position by purchasing calls. If you believe that the stock can go down quickly, purchasing puts may be a good idea. The options trader can also sell calls and puts if that person wants to take on additional risk in exchange for a premium. There also exist more combinations that allow you to take advantage of time, volatility and interest rates; however, they are discussed further in our Value Line Options Survey.
The Value Line Options Survey points out strategies that are worth looking at. It also allows the subscriber to take more advantage of the Value Line Investment Survey by finding the options strategies that will work with each issue. Pairing your portfolio with Value Line’s Options Screener, however, is the easiest way that a subscriber to The Value Line Options Survey can purposefully add leverage or decrease risk to his/her portfolio.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.