TLDR at end
The market has been on absolute tear since 2020. In times like these, investments like options come up and may seem tempting. After all, it seems like everyone else is making money with these things so why shouldn’t you?
Options are something that everyone knows about but few truly understand. That’s not surprising, because they are a complicated financial instrument. We’re going to walk through the basics of them so you can stay better informed. For 99% of investors all you need is a surface level understanding of options and how they are utilized by professional investors. This will keep you out of the latest investing fad and allow you to determine whether options make sense for your portfolio.
The Two Types Of Options
A call option gives you the right but not the obligation to buy 100 shares of stock X at a certain price by the expiration date. These are bullish because if the stock price goes up past the strike price you are going to make money. You make money because you can buy the stock for less than the market price using the call option.
A put option gives you the right but not the obligation to sell 100 shares of stock X at a certain price by the expiration date. These are bearish because if the price falls you make money by being able to sell your shares for more than market value.
It’s okay if you’re totally confused at what that means……
Options are derivative contracts whose value is based on the underlying stock. They don’t have intrinsic value, their price is derived from the price of the stock or commodity that they are written for. Options allow you to buy or sell (depending on the type) 100 shares of a stock at a certain price (strike price) at a certain point in the future(expiration date).
Their value is determined by whether that strike price is more profitable than the current market price. You can then sell the stock for more than its current price (puts), or buy the stock for less than its current market price (calls).
Interestingly, you do not have to buy or sell the shares at that price yourself. You can sell the contract for a profit once the underlying stock passes the strike price instead of exercising and using it to buy or sell the 100 shares yourself. This is how most people trade options.
American options are the type that are available on the NYSE. These options allow you to exercise the option at any point between buying and the expiration date. So, you can buy or sell (depending on the type of option) a stock at the agreed upon price at any point during the life of the option. Obviously, you would only do so if it were profitable to you.
If you have at least 100 shares of X stock or equivalent cash, you can sell options. The person selling the option is essentially betting against the person buying the option that the price will not be at or above the strike price by the expiration date. The person selling options is required to hold the 100 shares or cash as collateral during the life of the option. They may have to sell or buy those shares at the agreed upon price at or before the expiration date if the buyer chooses to use the option.
You pay a premium for the option. This is essentially the cost of the option because the seller is taking a risk by selling it to you. The premium is determined by:
How close the strike price is to the current price (making it more likely the option will be profitable)
The time until the expiration date. More time means you have longer for the price to move to the strike price.
Both of these factors increase your chance of success and increase risk to the person buying the option so the premium is more.
An option that has reached it’s strike price (the agreed upon price) is known as at the money.
If it reaches it’s strike price plus the premium you paid for it then it is in the money. At this point any upward price movements are pure profit.
If it has not reached the strike price then it is referred to as out of the money.
The Basic TakeAways
- An option is a contractual agreement between two parties about buying or selling 100 shares of X stock at a certain price at any point when it would be profitable to the buyer over a predetermined period of time.
- The party selling the options owns 100 shares or equivalent cash in order to make the option valid.
- The person buying the option and the person selling the option are betting against each other.
- A call option is valuable when you buy 100 shares of stock for less than market price. The person who sold it to you is betting this won’t happen because they have to sell their 100 shares of X stock at the price you agreed upon which is less than market price. They have to maintain at least 100 shares of the stock through the life of the option so they can’t back out.
- A put option is valuable when you can sell 100 shares of the stock for higher than the market value. The person who sold it to you is betting this won’t happen because they are required to buy those shares from you at a higher price. They are required to have that amount of cash on hand when they sell the option and throughout the life of the option so they can’t back out.
In order for either side to make money they need to meet the following criteria:
- They have to correctly predict stock movement. Either up or down depending on the type of the option but the seller is always betting the opposite direction of the buyer because they don’t want to sell or buy shares at a loss.
- They have to correctly time stock movement. Whether buyer or seller if the stock doesn’t move to where you want by the expiration date you’re out of luck. This is made more difficult for the buyer by the decay function. The decay function is driven by theta which you can read more about in the greeks section below. Options lose their value exponentially as they approach their expiration if they are out of the money. This is because it is increasingly likely the option will expire useless.
- You have to correctly predict the level of stock movement. Options by potential stock prices in $5 increments (known as the option chain). The further away from the current stock price the cheaper they are because it is less likely that the stock will move that amount. As out of the money options approach their strike price their value increases exponentially. This is because they are much more likely to actually be a valuable agreement before their expiration date.
There are two ways the buyer can profit from an option:
- Exercising the option and either buying or selling at the strike price. You get a good price relative to the market price at a loss to the seller of the option.
- The most common method is to turn around and sell the now much more valuable option on the market and pocket the difference at which you bought it and the current price.
The precise price of an option is determined by a few variables referred to as the greeks. We’ll just do a brief overview because these are nice to know not a need to know.
Getting to Know The Greeks
Delta: The rate of change between the option price and $1 of change in the underlying asset price. A delta of .65 means the option price would change 65 cents for every $1 change in the asset price. For a put option it is negative because you want the asset price to decrease.
Theta: The rate of change between the price of the option and the time remaining. If the option is in the money this is a positive value. If it is out of money it is a negative value. A theta of -.37 means the price would decrease by 37 cents everyday. Theta drives the time decay function of an option and is critical to understanding how an out of the money option will lose value as it approaches its expiration date.
Gamma: The rate of change between an options delta and the underlying assets price. It helps you determine the stability of an option. Gamma is higher for options in the money and drives the dramatic price change as you approach the strike price.
Vega: The rate of change between the options price and the implied volatility of the underlying asset. A more volatile asset has a higher vega and therefore a higher value because it is more likely the asset will move to the strike price (although it could go the other direction). More volatile stocks are more risky (think about Gamestop).
Takeaway: Option prices are primarily a function of time, volatility and its relative price change to the underlying asset which is affected by how close it is to being in the money.
Why Do Investors Use Options?
Investors use options to use leverage. This is because each option is associated with 100 shares of a stock. Options allow you to capture the price movement of 100 shares of a stock for far less money than actually buying 100 shares of a stock.
If you believe a stock price will go a certain direction then you can potentially make more money by buying X amount of options than using that same amount to buy stock. This is better than other ways to buy more stock such as margin because with an option you can only lose the amount you paid for the option. With margin you can lose more than you have.
If you pick the right calls, you can do what is known as a stock replacement strategy and use options to gain the upside for a stock at significantly lower cost out of pocket.
If you are bearish and believe a stock will decrease then you can either short a stock or buy put options. The margin requirements (money required) to short a stock are significant. And your loss is potentially unlimited because the price of the stock can increase dramatically and you’ll need to buy it back at that higher price. This is what happened to hedge funds with GameStop.
Alternatively, if you believe a stock will go down you can buy put options for a lot less and the maximum amount of money you can lose is the price of the option.
Takeaway: Options actually have significant advantages because of the low cost and leverage. This makes them both efficient and less risky than margin/shorting because you can only lose the amount you paid for the option. However with both puts and calls if your price movement prediction is wrong or doesn’t happen within the life of the option, it will expire worthless.
Do Options Make Sense For You?
If done right, options can increase your profit and make your money go further. That being said you will burn money on options every time you do not get it right. There are a lot of moving parts. Recall that to make money you have to both predict the price movement and time the market. Anyone who has read on investing knows that those are essentially the number one thing not to do. The timing part is probably the most difficult. The reason why is the shorter your timeline is the more random stock price movement is. It is very difficult (if not impossible) to predict price movement over the next few days, months etc.
Recall that the premium is a function of strike price and time to expiration. This means that a lot of stocks you may want to buy actually have really expensive options. So if you want to dabble in options you will be limited to stocks that have a cheap share price.
Example: Premium for call options on two stocks with September expiration and strike price 10% above current price:
- Current Share Price: $787.90
- Strike Price 10% above that: $865
- Cost of option: $16,825
- Current Share Price: $35.00
- Strike Price 10% above that: about $40
- (sold in $5 increments for this stock)
- Cost of Option: $950.00
Prices are from time of writing and are for illustrative purposes only.
As you can see options are based on the price of a stock because the strike price is relative to that. The ones that give you a good chance of profit (long time until expiration and not too far out of the money) are actually quite expensive. Yes, this is significantly cheaper than buying 100 shares of either stock. But it’s also ridiculous to pay either $1000, or $16000 in this case to learn the ropes with options.
If you have built up a decent and stable portfolio then there’s nothing wrong with throwing a few hundred dollars at options here and there. However, if you are working on building your portfolio then it makes a lot more sense to invest your money in something much safer. The first rule of building wealth is not to lose money. Any money you put towards options needs to be money you are okay with losing, because you probably will. Dabbling a few times is totally fine but it doesn’t make sense to keep throwing money at a losing investment. Put it towards building your portfolio with quality index funds or stocks instead.
Bonus: How to Read An Options Chain
An options chain is a list of the available options for a stock. The dates you see on top are the expiration dates. Options are sold in regular increments in this case 50 cents. The rest is fairly intuitive with RobinHood, you just toggle buy or sell or option and put.
Remember, options with a longer time horizon or are closer to the money are more expensive. Options that are closer to expiration and still out of the money will lose significant value everyday. Again, this is due to theta and the increasing probability that they will expire worthless.
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