Many investors have heard of options but dismiss them as too confusing. They have heard stories of people losing lots of money using them-after all they are derivatives. And some money management firms won’t engage in options activity at all for their clients, labeling them as too risky.1
Options certainly get a bad rap but proper use can actually reduce risk in a portfolio. While there certainly have been derivatives with large losses, the same could be said for traditional stocks and bonds. The predominant business model for asset managers rewards total assets under management, so there isn’t much incentive for them to utilize options, a transactional business. Learn the basics of options and then decide if options are something you should ask your financial advisor about.
What are Options?
An option is simply a financial contract between two parties. The option provides the buyer the right to buy or sell an underlying security at a specific price (known as the strike price) until a specific time period (known as the expiration date). The underlying security is usually a stock, a commodity ETF, or a major market index like the S&P 500. The contracts are typically bought and sold on an exchange, just like a stock, and one single contract typically represents 100 shares of the security but you can buy multiple contracts for greater exposure. For example, if you wanted to buy the right to control 1000 shares of Apple, you’d need to purchase 10 option contracts (10 contracts x 100 shares represented by each contract = 1000).
There are two main types of options-calls and puts. The buyer of a call option pays for the option (known as the premium) for the right to buy an underlying security. The buyer of a put option pays for the right to sell an underlying security. Notice it’s the right, not the obligation, to buy or sell the underlying security at a future date.2 This flexibility is why the option buyer pays the upfront premium.
On the other side of the transaction, the option ‘seller’ is obligated to buy or sell the underlying security to the option buyer depending on whether the buyer exercises their right. As the name implies, it’s the contract buyers ‘option’ whether to buy or sell (exercise) the underlying security. To compensate the seller for this obligation, the seller receives the premium paid for the option upfront from the call buyer.
A Simplified Call Option Example:
Say it’s March and you are bullish on ABC Company’s stock over the next couple months. You’re interested in buying 100 shares but the stock has a high share price, $100 per share, and you don’t have, or want to spend, the $10,000 to purchase the stock right now (100 shares x $100 per share= $10,000). So you decide to buy one ‘May 16 ABC $100 Call’ option that expires in two months’ time. The price of the option is $3.
Since one option contract is typically worth 100 shares, the exposure is the same (over that two month period) but your capital outlay is just $300 versus $10,000. You have effectively created leverage at no interest rate.
If the stock moves above the strike price of $100 the option’s intrinsic value begins to increase as the option becomes “in the money.” If the underlying stock tanks and remains this way until expiration the most you can lose is the premium you paid for the option, $300, and the option expires worthless.
Let’s say in the next few weeks, ABC stock reports strong earnings and the stock goes up to $109. Your option is now $9 “in the money” (the difference between its current price of $109 and your $100 strike price). Your option should be worth at least $9. In reality, the option should also have some remaining time value, maybe $0.25, which is another component of options price, so maybe it’s worth $9.25, but we’ll round to $9 for simplicity. Remember, you paid $3 for the option and you could sell it now for $9, tripling your money. That quick 200% ROI (return on investment) is what keeps options speculators coming back.
Of course, if ABC’s stock had gone south on a bad earnings report, your option would lose a significant amount of its value and the chances are it would expire out of the money and eventually worthless. So you could also sustain a 100% loss on the options trade. This is more common, as 76.5% of options expire worthless according to CME data.3
How are Options Priced?
There are several factors that go into determining the price of an option. Different variables include the price of the underlying security, the amount of time until expiration, the implied volatility in the market, the level of interest rates and how far the option is currently in or out of the money.
There several are other factors in play for options, all drawn out in the famous Black-Scholes options pricing model. Economists Fisher Black and Myron Scholes received the Nobel Prize for the model.4 Like the old confusing formulas from a textbook, these variables are represented by various Greek symbols.
Why the Need for Options
If you are considering a career in finance as a financial advisor, you definitely need to understand options. Even if your clients are retirees and never do an option trade, you’ll need to understand the basics to pass the dreaded General Securities Exam or Series 7.5
Proficiency with options provides you with additional tools to better manage your client’s portfolios. Through options, you can hedge existing positions with protective puts, make money in a flat market and take advantage of market volatility. Further, if you sell certain insurance products, it is important that you understand options. For example, if you offer a client an annuity with full downside protection, this is probably accomplished by a combination of derivatives including options, swaps and futures.
Benefits of Options
1-Provide affordable exposure
Options allow individual investors the opportunity to capitalize on market opportunities with limited, sometimes zero, capital outlay.
Today, option’s commissions are quite low, with some brokers advertising rates as low as $4.95 plus $0.50 per contract.6
Through the use of various option strategies, including ‘protective puts’, investors can hedge their equity positions against a variety of bearish scenarios.
Weaknesses of Options
While empirical evidence shows the advantages of a buy and hold strategy for stocks, the opposite is true for options. Since option contracts have a finite life (their time until expiration) the closer they get to their expiration, the less money they are worth, all else equal. This ‘time decay’ (also known as theta) and is the scourge of options owners.
Even with low commission rates, experienced investors can tell you that trading options on more obscure, lower volume securities can quickly become expensive. This is because the less traded a security is, generally the wider the bid-ask spread is. So on a round trip options trade (a buy and consequent sell) you may have to pay much more than just the commission. This is known as ‘flip adjust’. This is not a problem when trading highly liquid underlying stocks like Apple, GLD or SPY where the bid ask spread can be a couple pennies. But in the options market you could pay up to 50% just by paying the full bid-ask spread. Options 101 tip-when trading options, be sure and use limit orders, not market orders. There are around 4000 optionable securities so you have quite a selection of liquid ones to choose from.
3-May Lose Significant Value
If your option trade isn’t working out as planned, your option can expire worthless and the entire amount of the premium you paid could be gone. This certainly is a drawback but remember, any stock can become worthless. Before their individual troubles, few predicted WorldCom, Lehman Brothers or Adelphia Communication’s stocks would become worthless. Looking back at a chart of these stocks just a year earlier, all seemed fine.
With an increasing emphasis on alternative investments, more and more investors are turning to options to help reduce risk in their portfolios. Typically, anyone can trade options which require just an options agreement with your broker. But you should always consult a financial advisor before pursuing any type of options strategy because they may not be for everyone. There are also several different types of advanced options strategies for more experienced investors. Learn more about options in subsequent articles, Options 201 and Options 301.