Just what are options?
We’ll kick off our exploration of options in this Buying Options Guide with a basic definition, just so that you’re clear about what options are. Try to put aside what you already know for a moment while we walk you through the details of options buying. Hopefully you’ll end up with new insights and a fresh understanding.
The first step is to be clear about what options are in the world of trading. You’ve probably heard them described as a subset of a broader group of securities called “derivatives.” For many of you, that may set alarm bells ringing: Warren Buffet famously referred to them as “weapons of mass destruction”, instruments that are associated with excessive risk taking and capable of bringing whole economies to their knees. It was, after all, mortgage-backed derivatives of a specific kind that caused the global banking crisis of 2008. But take a deep breath: the number of different securities that come under the rubric “derivative” is vast, and the overwhelming majority of them were entirely blameless at that time. “Derivative” means what it implies: the price of various options is derived from (based on) the price of something else, just as ketchup is derived from tomatoes and wine is derived from grapes. In this sense, a stock option is derived from a stock. And for people who like to see financial results sooner rather than later and are deciding between buying options vs stock, options may be just the ticket.
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Call Options: down-payments on future developments
Essentially, buying options entails buying an options contract, which endows the buyer with the right (but not the obligation) to buy or sell an underlying asset at a specified price on or prior to a specified date. By convention, we break down buying and selling into two types of option: a Call Option allows the holder to buy stock, while a Put Option allows him or her to sell stock.
We’ll explore Call Options first, which are effectively down-payments for a future development. An analogy may be useful here: if you’re a prospective homeowner and you see a new property development under construction, you might like to secure the right to buy a home there – but only when other developments (like, say, a school and a garbage dump) near the area have been completed. If they never appear, you may not wish to exercise your right, but if they do, you would. Having the right to buy under the right conditions would clearly be an advantage. So, for instance, buying a Call Option from the developer to purchase a home at, for example, $400,000 at any stage in the coming three years would be a canny move. But you wouldn’t expect the developer to give you such an option gratis. To lock-down that right, you’d be reasonably expected to make a down-payment, or a “premium,” to use the terminology of options trading. Let’s pursue this analogy a little further to illustrate buying stock options.
How small down-payments/premiums can morph into big gains
The premium or down-payment is the cost of a call option (more precisely, it’s what you pay to secure a call option contract). To stay with the home-building analogy a little longer, the down-payment or deposit the property developer might require may be in the region of $20,000 (i.e., 5%). That’s enough to give you and the developer skin in the game (he’s going to want the development to be attractive to you), but not anywhere near as much as the eventual commercial value of the completed home.
Fast-forward two years: the homes are finished, zoning has been approved – but the latter doesn’t include a garbage dump. The market value of the home, however, has soared to $800,000 since you made your down-payment (the equivalent of buying a call option contract on the development). It’s a no-brainer: you’d pay the $400,000 without further delay, before your time window expires and you lose the right to buy. If you’d waited for zoning approval for the garbage dump, you may have exceeded your agreed time window and would have to take your place in the market scramble to buy the home at the full market price (in options terminology, your call option contract would have expired). In both scenarios, the developer holds on to the original $20,000 premium. Having walked through a direct analogy, now’s a good moment to move onto buying stock options more formally.
The flip side of buying stock options: selling, and the role of Put Options
Instead of picturing a house, think about how this might work with a stock or an index investment. The deposit or premium was a form of insurance in the home analogy. In a virtually identical way, an investor may want to insure his or her S&P500 index portfolio. This may be especially pressing if the investor fears that a bear market is approaching and wants to ensure that no more than 10% of his/her long position in that index is sacrificed. If the S&P500 is trading at $2500 right now, the investor can buy a Put option contract that grants the right to sell the index if it reaches $2250 within the coming two years. In other words, while the home analogy focused on buying, the Put Option comes into play when it makes financial sense to secure a right to sell.
With the Put option we’ve just described, the investor can still sell at the agreed $2250 even if the market nosedives by 20% (or 500 points on the S&P) and the index is trading at just $2000. The investor could sell at that agreed price even if the market crashed to zero: the loss for the investor would be pegged at just 10% as agreed at the point of purchase, provided the crash occurred within the agreed time window. Should the market remain resilient and the index remain buoyant, the maximum loss to the investor would merely be the cost of the premium.
Buying options: Rights without obligation
We can boil these two scenarios down into three fundamental and crucial points. Firstly, when you purchase an option contract, you’re purchasing the right to do something with it in the future, not an obligation to do something with it. Because the right can be exercised in the future, this form of trading is sometimes referred to as “futures.” The key takeaway here is that the ‘call’ or ‘put’ option contracts are simply rights to buy or sell stock before expiration of the contract.
We’ll throw another consideration into the mix at this point. As with most forms of trading, you’ll need to rely on a good broker to exercise your options and implement effective trading strategies for you under the right circumstances, which is why doing some careful broker comparison research before you start parting with your savings is so important. You need someone you can trust and who inspires confidence. If the option you purchase still has value at expiration, your trusted broker will in most instances automatically exercise the option. To return to the Put example in the paragraph above, if the S&P500 plunged to zero upon expiration of the contract, the Put would still be worth $2250. That means that upon expiration, the Put option could be settled for the cash value, resulting in a sizeable gain on the hedge. Alternatively, if the index soared to $3000 at expiration, your original $2250 would be worth nothing. Let’s move on to the second and third points.
Limited losses and near-unlimited options
The second point is worth bearing in mind at all times: when you buy an option contract, the most you can lose is the premium you paid at the outset. For many traders, that’s one of the most attractive features of selling and buying stock options. When your risks are limited in this way, you get to sleep easily instead of fretting endlessly under the duvet when market conditions take a bad turn. It’s hard to put a price on this, but most people who’ve suffered bouts of extended anxiety will testify that restful nights are immeasurably valuable. You tend only to appreciate them when you can no longer have them; options contracts can restore them.
The third point to weigh up is this: options cover a wide array of different financial beasts. The option you’ve purchased is a contract on an underlying asset. The price you pay for it is derived from that asset’s value (which is why, as we explained earlier, options are in the “derivatives” camp). Typically, the underlying asset will be a stock or a stock index like the S&P500. But they’re by no means confined to stocks and stock indexes. Options are also actively traded on a huge raft of different financial securities, including foreign currencies, bonds, commodities and other derivatives, too. To round off our Buying Options Guide, we’d like to take you through some more terminology to help you navigate a productive path through this complex but intriguing trading model.
Core terms in selling and buying stock options: Holders and Writers
Buyers of options are called “holders” while those who sell options contracts are called “writers”. Writers (who are sometimes called “grantors”) open a position to collect a premium from the holder when they sell an option contract. The call or put options writers sell take two forms as a general rule: covered and uncovered (or “naked”). An example: a writer owning 100 shares of stock may sell a call option on those shares to a holder for a premium. The position is said to be “covered” because the writer owns the stock underlying the option and has agreed to sell those shares for the price of the contract.
Both put and call holders are under no obligation in the contracts to sell or buy options, so the risk they shoulder is confined to cost of the premium they paid. This is different for writers: both call and put writers are obliged to sell or buy if the option expires “in-the-money” (i.e., trading above its price at the time of the contract). In other words, writers may be obliged to make good on a promise to buy or sell and are therefore exposed to more risk than holders. But essentially for holders, there are four things that can be done with the options they’ve purchased: they can buy call option contracts, sell call option contracts, buy put option contracts and sell put option contracts.
Hopefully it’s now clear to you that options are derivatives (because their value is derived from an underlying asset) and are contracts that allow their holders the right to buy or sell within a specified period with no obligation to do either. Call options are buying options, granting the right to buy an asset at a specified price inside a specified time window, while Put options grant the right to sell an asset at an agreed price within the defined time period. The total cost of an option contract is known as the premium and may be higher if the chances of reaching expiry “in-the-money” (i.e. above the originally agreed trading price) are good. Selling and buying options are widely seen by investors as an excellent way of hedging against risk. For people who prefer faster results on their investments than waiting it out in stock trading, buying stock options may be the optimal choice.