What are Options

Good morning! Today Troy continues with the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s

Options are complex financial instruments. There are 2 types of options:

1. Call options, the equivalent of buying stock (betting that prices will go up).
2. Put options, the equivalent of shorting stock (betting that prices will go down).

A call option gives you the right but not the obligation to buy a stock in the future at today’s price. However, in order to buy this right the purchaser of a call option needs to pay a premium. Here’s an example. Let’s say Apple stock is currently at $500 a share. If I buy a call option on Apple, I will pay a $50 premium for the right to buy Apple stock at today’s price before December 31, 2013. If Apple stock closes above $550 (500+50) before December 31, 2013, I just made a profit (the difference between the future stock price and today’s price+premium). However, if the stock price does not reach at least $550, I will lose money.

Thus, an option is assymetric. Your losses are limited to the premium you pay, but the potential profits are unlimited.

A put option is exactly the opposite. It gives you the right but not the obligation to sell (short) a stock in the future at today’s price. Likewise, you must pay a premium. Using the same example (but with a put option), let’s say that Apple’s stock is at $500, and I pay a $50 premium to sell Apple’s stock at today’s price before December 31, 2013. If Apple stock closes below $450 (500-50) before December 31, I will make money. However, if the stock does not fall by at least $50, I will lose money. Like a call option, a put option is also assymetric.

Relative Directional Investment

Investing in a stock or an ETF is a purely directional investment. You are betting on the direction of the stock or ETF’s price (up or down).

An options is different. It’s a relative directional investment. I’ll explain what that means.

In a relative direction investment, all three requirements must be met in order to make money.

1. The market must move in your favorable direction. For example, if you bought a call option, the market needs to go up in order for you to make money.
2. The market must move in your favorable direction by a minimum amount determined by the premium. If you bought a call option and paid a $50 premium, the market must go up by at least $50. If it goes up by only $30, you just lost $20.
3. The market must move in your favorable direction by a minimum amount before a certain date.

Options are Insanely Volatile

Options are a very volatile market. You can make a ton of money in a jiffy, but you can also lose your shirt even faster. Here’s an example.

Using the same Apple stock, let’s say you have $500 in your investment account. Apple stock is trading at $500 a share right now. Below are two scenarios.

1. You outright buy 1 share of Apple stock for $500.
2. You buy 10 call options that each has a $50 premium. These options expire on December 31 2013.

Let’s assume that Apple stock rose to $600 before December 31 2013. If you had outright bought 1 share of Apple, you would have made $100. That’s a 20% profit. If you had bought 10 call options, you would have made $50 on each option, with a total profit of $500 (10×50). That’s a profit of 100%!

On the other hand, let’s say Apple stock fell to $450 before December 31 2013. If you had bought 1 share of Apple, you lost $50, or 10%. If you had bought 10 call options, those call options would expire worthless. In other words, you just lost 100% of your money.

I have some friends who don’t spend a lot of time monitoring their investments, and I cringe when they talk about their options investments. Needless to say, they’ve lost a lot of money.

This post was featured on the Carnival of Money Pros, Aspiring Blogger, thank you!