Options 101
Trading shares of stock has become as common as surfing the Internet. But, like any financial investment, trading stock is risky. The price can fall unexpectedly and stay down for lengthy periods. To offset that risk, and to trade with more funds than you have without borrowing, options are… well, an option.
An option is a contract giving the investor the right to buy or sell some instrument at a given price on or before a stated date.
Options contracts are written on all sorts of underlying assets: real property, stocks, bonds, even movie screenplays. (Though the latter trade on a rather different sort of exchange…)
The basic idea is simple. Invest a (relatively) small sum today, to control something worth a larger amount today. Bet that the price will move in a given direction before a certain date, then sell and pocket the difference.
For example, suppose Google shares are selling at $400 per share. But buying 1,000 shares of GOOG (the symbol for Google stock) at $400 each would cost $400,000. That’s a substantial investment of cash, one beyond the means of the average investor.
Even buying on margin (borrowing) would typically get you only half the way there. Most stock brokers will lend their clients only up to 50% of the total cost. (There are laws restricting them, in any case.)
But, you can still ‘own’ 1,000 shares of GOOG. Simply buy an option at, say, $20 per share (the ‘premium’). Now your investment is $20,000 – hefty, but within reach. (That’s called ‘leverage’ – controlling more than you own.)
Every option has an expiration date – the date by which the investor must ‘exercise his option’, i.e. execute a decision to buy/sell the instrument or lose his invested money. Depending on the underlying asset, and other factors, the date can be anywhere from a day to several months hence.
Options also have a strike price – the price at which the underlying instrument has to be bought or sold when exercising the option.
Continuing the example, suppose the option for GOOG expires in 30 days and has a strike price of $410. The break-even price would be $410 + $20 = $430 per share. At this point, you are ‘under water’ by $30 per share x 1,000 shares = $30,000. Ouch!
(Note: ‘Under water’ is – obviously – not the same amount as your investment. It’s the amount you have to rise to reach break-even.)
But, three weeks pass and Google announces some good news about earnings. The price per share rises to $440. Now you can exercise your option (‘close your position’) and sell.
The options contract price has increased as well, to $25. Your profit is: ($25-$20) x 1,000 = $5,000. (Ignoring broker fees.) Not bad. That’s a 25% profit on a $20,000 investment. (Of course, prices fall as well. More on risk and hedging strategies later.)
Options aren’t for everyone. They’re more complicated (though not too much), riskier, and generally involve shorter term trades and the requirement to watch the market more closely.
But note that purchasing the options contract did NOT involve investing 5% ($20/$400 x 100%) and borrowing 95% of the funds. Options contracts are a straight investment of funds, not a broker loan.
If the price goes in the predicted direction before expiration, you make money. Otherwise, you lose (some or all of) your investment.
As with any investment, do your homework. Make sure you understand how options work and what the relative risks are. In particular, study the market for that type of underlying instrument. Throwing darts blindly is the least successful options trading strategy.
Good luck… or should we say, good research.
Hedging, Trim Risks Not Bushes
Options are frequently used in hedging.
A hedge is an investment made to offset the risk incurred by entering another investment. Ironically, the basic idea is to bet against oneself, in a way.
Speculate that the market price will rise in the future and buy a call today. (A call is an option that confers the right to buy an asset at a set price in the future.) But, knowing that any price rise is uncertain, simultaneously buy a put. (A put is an option to sell at a preset price in the future.)
Now, why would anybody do such a crazy thing?
Well, hedging is, at bottom, a form of insurance. Though there are traders who use it more actively as a profit seeking strategy, such as hedge fund managers. By carefully selecting the appropriate combinations of strike price, expiration date and type of option an investor can minimize risk and maximize the probability of making a profit.
How?
As an example, we’ll consider a common hedging strategy: the Strangle. No, that’s not something you do to your broker. That would be increasing risk, not minimizing it.
In this strategy, an investor holds both call and put options with the same maturity, but with different strike prices.
The contracts are purchased ‘out of the money’ and are therefore cheaper. ‘Out of the money’ means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the current market price.
Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)
If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options. Therefore the risk (‘exposure’) is limited to $500.
Suppose the price drops near expiration to $15. The call would expire worthless, but the put is worth ($25-$15) x 100 = $1000 – ($2 x 100) = $800. Subtract the cost of the call, $800 – $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.
The difference between the exposure and the potential profit represents a kind of hedge. Though the investor is, in a sense, ‘betting’ that the price could go either way, his downside is limited to the combined cost of the put and the call.
There are, not surprisingly, nearly as many hedging strategies as there are investors. A couple of common types are:
The collar: Hold the underlying asset and simultaneously both buy a put and sell a call of the same asset. The short call limits gains, but the long put hedges against any losses from the underlying asset.
The protective put: Buy the asset and also buy a put option on the same asset. At expiration, the asset may have gained (eliminating the value of the put option), but the rise in the asset offsets the loss.
Exotic combinations abound, but most involve speculating on the price direction of the underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. As with any investment strategy, make sure you understand the pros and cons before laying down your bet.
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