An Introduction to Options

Options are among the most versatile investments available to individual investors. They also might be among the most misunderstood.

Options are low-priced derivative contracts that can help improve investment results or they can help reduce risks. Options can also be used to generate income. Unfortunately, many individual investors believe options are too risky for them. The truth is, when used properly, options can be a low risk way to increase and protect wealth. In future articles, we will explain specific trading strategies for options. This article will provide an overview of the trading instruments.

As the name implies, trading options gives the trader a choice. Options give the buyer a right, but not an obligation to buy or sell a specific stock or ETF at a predetermined price within a specific timeframe. Because there is no obligation associated with buying options, risks are strictly limited to the amount paid for the option. This can often be a small amount of money, frequently just $100 to $500. Some options contracts will cost less than $100. Buyers could double their money or make even larger profits than that. They could also break even, earn a small profit or suffer a small loss. But buyers can never lose more than their investment.

Standardized options contracts have been around since 1973 and are increasingly popular with investors. More than 3 billion contracts are traded annually in the United States. The popularity of options lies in the fact that they give a trader flexibility, reduce and limit risk, and offer high potential returns.

To understand options, we can start by thinking about buying an option on a house. In fact, many commercial real estate deals do involve options. For example, you want to buy a home for $500,000 within three months. In this option, we have a specified price and a specific timeframe. In exchange for this option to buy, you pay the seller 1% of the proposed purchase price or $5,000, an amount referred to as the premium by options traders. Two weeks later, you learn that a nearby airport is going to expand its runways and will be purchasing all of the surrounding property, including your new home, for 50% above their market value. Because you have an option to buy at $500,000, your purchase price is locked in. Your new home just went from being worth $500,000 to $750,000 and you just realized a $250,000 profit on a $1,000 investment. Obviously this is an example to explain options and is not an example of the type of returns you should expect in the stock market.

On the other hand, say over that same time period you discover that the home is infested with termites and is structurally unsound, needing $300,000 in repairs. Your new house just went from dream home to money pit. Because you have an option to buy, not an obligation, you can walk away from the contract, lose your $5,000 premium, but save yourself $295,000 in repairs.

Options on stocks or ETFs work the same way — giving the buyer the right, but not the obligation, to buy at an agreed upon price. As in all investments, there are potential risks as well as potential rewards. However, with unlimited upside potential and limited downside risk, options can be a good deal for the buyer. The seller absorbs all of the downside risk above the premium you pay for the option, but the seller pockets the entire premium if the option declines in value over the life of the contract.

There are actually two types of options a buyer might purchase.

A call option gives the buyer the right, but not the obligation, to buy 100 shares of a stock or ETF at a predetermined price for a specified period of time. A call increases in value as the price of the underlying stock increases. If you are bullish, which means that you expect the market to go up, you could purchase a call option.

A put option gives the buyer the right, but not the obligation, to sell 100 shares of a stock or ETF at a predetermined price for a specified period of time. A put option increases in value when the underlying stock declines in price. Bears might buy a put option which would allow them to profit from the expected decline in the market. Owners of puts are in effect selling at a high price now and hoping to buy the stock later at a lower price. Their goal is still to buy and sell high but the steps are reversed from the usual investment process.

Option contracts generally cover 100 shares of stock. In a few stocks, there are mini-contracts covering just 10 shares. The same ideas apply whether you trade full sized or mini-contracts.

As with any investment transaction, there are two sides to any options agreement, the buyer and the seller, who is known as the writer. The buyer has a right to exercise the option if the underlying instrument moves in the buyer’s favor. On the other hand, the writer is required to meet the terms of the options contract if the buyer exercises the option. Exercising an option means executing the trade in the contract at the agreed upon price no matter what the current market price is.

Options generally trade for small amounts of money, often less than $1. Because a contract covers 100 shares this would cost less than $100. If a stock rises by $5, the call option could increase by $500 and deliver a large gain to the trader. Risk is limited to the amount paid for the contract. Likewise, a put option could increase in value by $500 if the stock falls by $5.

That last point is one of the reasons options buying is so popular with traders. While the amount of money that the buyer can make is unlimited, the risk associated with the purchase is limited to the amount of the premium paid, and that is usually a small amount of money.

Options are usually associated with short-term trading strategies. In recent years, exchanges have listed contracts that expire 12 to 24 months in the future. Long-term options can be a way to make long-term investments with small amounts of money.

Because the trader has the luxury of time on his side, it will cost more for a long-term option. This is because the longer time to expiration provides a significant amount of time for the stock to move above or below the option’s exercise price.

Options are a great tool to leverage investments. For example, Apple (Nasdaq: AAPL) frequently trades at more than $100 a share. A call option can cost less than $5. Instead of spending $10,000 or more for 100 shares, call options allow you to benefit from a potential increase in 100 shares with just $500. Options traders will not receive dividends but they do participate in price gains and their upside is virtually unlimited.

Options are also a great tool to help you manage risk. The downside for options you buy is strictly limited to the amount you invest.

Another advantage of options is that they require less trading capital to get started. These investments might be the best way for many investors to diversify their portfolio with limited capital. But, options are not a buy and hold investment. You will need to actively manage positions and we will be detailing that process for different strategies in additional articles over the next few weeks.