- An option is a contract giving you the right but not the obligation to buy or sell an asset at a specific price before a specific date.
- If the asset doesn’t perform as hoped, the option just expires; you’re only out the small premium you paid for it.
- Though low-risk, options do incur costs, and require careful timing and market-watching to succeed.
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Every investor wants to profit from their investments, of course â€” choosing the right time to buy or sell. What if there were a way to lock in a price on, say, a stock, and then waiting to see how it performs â€” without having to purchase it?
Enter options. Options give you the right to buy or sell a given stock (or other asset) within a given timeframe, without having to pay for it upfront at its actual market price. This way, traders actually buy the stock only if it has moved in a favourable direction for them â€” the way they predict it will go.
Options aren’t new, but they have become more popular in recent years, not just among professional traders, but among ordinary investors. In 2020, options trading reached a record level: 7.47 billion contracts were traded, according to the Options Clearing Corporation.
Yet as widespread as options now are, they still remain something of a mystery to many. They’re actually not that hard to understand, however â€” once you pierce through the jargon.
What are options?
An option is not actually an asset itself, but an agreement. It’s what’s called a derivative: a contract between two parties â€” an investor and a brokerage â€” whose value is based on, or derives, from an underlying financial asset, like a stock.
In the case of options, this contract has to do with purchasing the asset. “An option gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a specific date,” explains Robert Ross, a senior equity analyst at Mauldin Economics.
There are two types of options: calls and puts. A call option gives you the right to buy an underlying asset within a certain period, while a put option gives you the right to sell an asset within a period.
Either way you have to pay for this right, and for the option. The cost of the option is known as its premium. It’s a per-share fee (option contracts are typically for 100 shares of the underlying security). The exact amount of the premium also depends on:
- the price at which option-holder might buy or sell the asset, known as the strike price
- how far into the future the option’s expiration date is: the more distant the date, the higher the premium
So buying an option is a bit like putting down a nonrefundable deposit on something â€” giving you the right to decide whether to actually buy it later. Options contracts typically run for no more than nine months.
Options can be applied to a variety of securities, but equities are the investment of choice. “Most traders focus on stock options trading,” says OANDA senior analyst Edward Moya.
Types of options
Securities that you can buy options on include:
- Commodities, such as gold, oil, or wheat
- Exchange-traded funds
- Stock market indexes, such as the S&P 500
Options trading examples
To show how options trading works, let’s walk through a couple of scenarios.
Call option example
Let’s say you buy a call option for Big Tech Company with a strike price of $US500 and an expiration date of a month from now. The lower this strike price is in relation to the Big Tech Company’s current price, the higher the premium you’ll have to pay.
Let’s say your premium is $US10 per share, and the options contract is for the standard 100 shares. This means you’ll have to pay a total premium of $US1,000 for the option. However, if shares in the Big Tech Company rise to, say, $US600 before the expiration date, you’ll make a profit of $US100 per share, or $US10,000 in total (minus the $US1,000 premium).
Put option example
Conversely, buying a put option means that you’re counting on the price of the Big Tech Company falling before the expiration date. If you have the same strike price of $US500, yet shares in the Big Tech Company fall to $US400, you’ll make a profit of $US10,000 again (minus your premium). That’s because your strike price ends up being higher than the actual price at expiration.
Needless to say, if the underlying stock doesn’t fall (or rise) the way you hoped, meeting or exceeding your strike price, you simply let your options contract expire. Remember, the option didn’t obligate you to buy or sell anything, it just gave you the chance to. The only thing you will have lost would be the money you paid for the premium.
Why invest in options?
The main attractions of options trading include:
Rights without obligations: Trading options grant investors buying/selling rights over particular shares, but without the cost that comes with actually buying those shares outright. It’s an easy, low-risk way to watch a red-hot stock â€” like electric car-maker Tesla was in late 2020. The idea of “controlling 100 shares of Tesla stock for a fraction of the cost attracted many investors to options,” says Moya.
Hedge risk: If you own a big stake in a stock outright, you can use an options contract in order to reduce potential losses.” A conservative investor may use options to hedge a large position,” says Robert Ross. For example, if an investor owns a significant number of shares in Company X, they can alleviate their risk by buying a proportionate number of put options on the same company. By doing this, they have the option to defray some of their losses if Company X falls in price since the put option’s strike price will likely be above Company X’s actual price.
Provide income: “You can sell puts and calls, which are conservative strategies to earn income on a position you own (i.e. calls) or a position you want to own (i.e. puts),” says Ross. By selling either a put or call option, traders will pocket the premium paid by buyers. Bearish traders will sell call options in the hope that the underlying asset doesn’t rise above the strike price, in which case they won’t have to sell it. Conversely, bullish traders sell put options in the hope that the underlying asset rises above the strike price, in which case they won’t have to buy it (and can therefore pocket the premium).
Are options risky?
Options trading does come with a number of risks.
- Money for nothing: For the buyer of an option, the most obvious danger is that the underlying asset doesn’t move in the desired direction, forcing them to let the contract expire. So, they paid the premium for nothing. Have this happen often enough, and it can add up.
- Careful timing: Options trading doesn’t simply necessitate an accurate prediction of whether a stock will go up or down, but also an accurate prediction of when it will make its move. You may be correct in thinking that The Big Oil Company is going up, but if your option expires before it surges, you won’t be compensated for your premium with a profit. In some ways, “options trading is a lot harder than normal stock investing because you not only have to get the direction right, but also the timing,” says Edward Moya.
- Costs: As with any kind of trading, options trading incurs costs. Not only are you obliged to pay a premium on your options, but you’ll also have to pay commission to your broker. Because of this, it always makes sense to weigh likely costs against likely profits (and losses) before purchasing an options contract. Otherwise your profit may end up being less than you imagined, or your loss greater than imagined.
Where to trade options
Options trading is most suitable for more experienced retail investors, particularly those who carefully research their trades and have a predefined strategy.
And there is a growing roster of places where they can trade options. Along with the established names (Fidelity, Charles Schwab, TD Ameritrade), some of the best online brokerages for options trading for individuals include:
The financial takeaway
Options let their owners buy or sell a specific number of shares of an underlying stock at a specific price until a specific date. They come in two main types â€” call (buy) or put (sell) options â€” and they can be for any kind of asset, although they’re most commonly used with stocks.
The main benefit of options trading is that it gives traders buying or selling rights over stocks for a fraction of their market price. The fact that an option doesn’t oblige you to trade the underlying asset means you have the choice of buying or selling only in favourable market conditions.
Of course, options trading isn’t without its risks. This is why they’re better suited to institutions and the more experienced retail investor since they usually require research and the dutiful use of a hedging strategy.
However, if due care is taken, options can be a highly effective means of profiting from the rise, or fall, in an asset’s price. Just be ready to keep an eye on your optioned stock’s moves, and be disciplined in your use of them. Says Moya: “Investors should ideally have predefined profit and loss targets on every options trade.”