Stock options can be a useful tool for investors, to often optimize returns as well as reduce risk. They have gained some popularity amongst individual investors in recent years. Basic option strategies can be useful for many investors and can be used without undue risk. Here is what investors need to know to get started with stock options.
An option is a contract that gives the holder the right to either buy or sell a security in the future at a set price. The purchaser of the contract is the option holder. The purchaser pays a price called a premium for the contract. It is important to note that the holder has the right to either purchase or sell the underlying security but is not obligated to purchase or sell the security.
The two basic transactions for getting started with options are puts and calls.
A put is a right to sell a security in the future at a set price, a call is an option to buy a security at a set price in the future.
The price at which the underlying security can be sold, for a put option, or purchased, for a call option, is the exercise or strike price. A standard option contract for a stock would be for a 100-share block of the underlying.
Options contracts can be bought for different time periods, generally, longer terms will be more expensive, as there is a greater chance of the price of the underlying changing enough to put the option in the money.
Let’s start by looking at calls.
A call option gives the purchaser the right to purchase a security in the future. Let’s say, for example, that an investor is interested in purchasing XYZ stock. They believe that there will be developments coming out that will drive the stock price significantly higher in the next couple of months.
Our investor has the funds to buy 100 shares of stock, or 200 if his or her brokerage firm can lend some of the money to buy the shares. . By purchasing these shares, he or she assumes all the normal risks of stock ownership, including the ability to lose all the investment, and conversely has an upside potential of the gain on either 100 or 200 shares.
If instead, our investor buys a call option on the stock, the investor can leverage this opportunity without taking on a great deal more risk. Buying a call – also referred to as a long call as the investor owns the call – might allow the investor to use the money that would have purchased 100 shares to get eight or nine option contracts. Each contract gives you rights to 100 shares.
The strike price would be several dollars above the current price, and for the purpose of our example let’s say the contract would be good for 60 days. If at the end of the contract, the stock is selling for above the strike price, the option will automatically be exercised, and the investor will have the gain between the price at that point and the strike price. The investor is utilizing the same money they would have used to purchase 100 shares to get options on eight or nine hundred shares and potentially see a much greater return.
The investor is assuming additional risk. Let’s look at the risk picture closely.
If the investor were to purchase 100 shares of XYZ, they would likely have some value at the end of the contract, it is rare for a stock to drop to zero in value in the immediate future.
The option contract, on the other hand, will either be profitable, aka in the money, or it will expire, and the investor will lose the premium that they paid for the contract. The downside risk of a long call option is the premium, that’s the most the investor can lose. If the investor is looking at an equal quantity of shares, they will have less total short-term risk with the option, there is a lower potential loss between the time of purchase of the option and its expiration.
A put option gives the option holder the right to sell a security at a point in the future. An investor might want to buy a put if they believe the value of a security will decline significantly in the near future. It works a lot like a call but in the opposite direction. An investor can buy a put, and if the price declines below the strike price at the expiration of the contract the investor will profit.
The investor stands to lose, at most, the premium they paid for their put. An alternative would be to sell the security short, meaning selling a security you don’t own, planning to buy it later when the price drops and gaining the difference. This involves a lot more risk than the put.
Selling short has unlimited risk.
There is no limit to how much the value of the underlying security could climb, and no limit to what the investor might have to pay to purchase the security to close the transaction.
A put option can be used defensively by an investor who owns a security. The investor may have long-term faith in the security but be concerned about the potential for near-term loss of value. By purchasing a put on that security, they provide themselves some downside protection, if the price of the security declines dramatically they make money from the option, offsetting the loss on the underlying.
Investors can make money selling options, but this generally involves more risk and reduces the investors’ upside potential. For example, an investor who sells a call on a security they own gains the premium they receive but limits their upside potential if the underlying climbs in value significantly. If they sell a call on the security they don’t own, they take on enormous risk for a relatively small gain of the premium. Most investors starting out with options will purchase puts or calls until they gain sufficient experience to decide if they would like to enter the riskier waters.
The Bottom Line
Investing with options is not for everyone. It requires a good deal of understanding and a good deal of involvement, or it requires placing a great deal of trust in someone doing this for you.
It’s never a good idea to invest in something you don’t understand well.
Trusting options in someone else can save you time but may not be worth the risk unless you fully understand what is being done on your behalf.
Not being for everyone is different from not being for anyone; some people are comfortable assuming an additional amount of risk for potentially greater return and feel they have sufficient time and knowledge to get involved. Options can be used to leverage returns, or to protect against undue risk, depending on the needs and desires of the investor. If getting started with options seems appropriate for you, it may be time to dig deeper or speak with your investment advisor.