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What is an option and how are they used in investing

Increase your investing profits by using derivatives

By Sudhir SahayPublished 2 months ago 11 min read
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What is an option and how are they used in investing
Photo by Joshua Mayo on Unsplash

Wall Street has always been able to attract brilliant and clever people who create innovative financial instruments. These innovations have made the people who created them lots of money, but also at the same time, they have helped democratize finance for the average person.

One such innovation is options. In today’s article, we will discuss what is an option, how they work and how they can be used as part of your investment portfolio.

What is an option and how does it work?

Let’s go to my standard place for getting basic definitions and examples of financial instruments, Investopedia. According to their explanatory articmle which I’ve used to inform this section:

An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price, referred to as the strike price, prior to or on the expiration date.

Options provide the buyer the right, but not the obligation, to transact at the price that is specified in the contract. While options can be bought and sold on a number of different types of securities, we will use options on stocks for this article to walk through how options work. We will also focus on American options which can be exercised at any time prior to the expiration date vs. European options which can only be exercised on the expiration date.

Each option has three key elements:

  • Underlying security: Options are contracts to transact on other securities. They are examples of derivatives as their pricing and value are “derived” from the underlying security. For stock options, the standard contract is based on 100 shares of that underlying security. So, for example, an option on Disney stock is based on transacting 100 shares of Disney
  • Strike price: This is the price at which the underlying security is transacted. When the option is “exercised”, the transaction is executed for the underlying security at the strike price
  • Expiration date: This date specifies the term of the option

Puts and calls

There are two different types of options, each of which you can buy and sell:

  • Put options: These give the buyer the right to sell the asset at the strike price within the term of the option. These options grow in value as the price of the underlying security decreases
  • Call options: These give the buyer the right to buy the asset at the strike price within the term of the option. These options grow in value as the price of the underlying security increases

In-the-money vs. out-of-the-money

In addition to the elements referenced above, there is also the concept of “in-the-money” and “out-of-the-money” options. This simply means whether or not the option has any value. For example, a put option is in-the-money when the price of the underlying security is below the strike. Likewise, a call option is in-the-money if the price of the underlying security is above the strike price. Options can only be exercised when they are in-the-money.

How do options get priced?

Like any financial instrument, you have to pay a price for buying options. This price is called the premium. If you decide to sell options, you get paid the premium by the buyer. Of course, that premium is either increased as a buyer or decreased as a seller due to commissions and fees.

Options are bought and sold on exchanges, so the pricing is based on supply and demand. However, generally, premiums are correlated with the a number of factors which can be used to calculate the value of that option using models such as the Black-Scholes model:

  • Current price of the underlying security vs the option’s strike price: As the value of an option is derived from the underlying security, current pricing of that security plays a core part in the value of an option. Called the intrinsic value of an option, option pricing starts based on the difference between the current price of the security and the strike price of that option. As an example, a call option with a strike price of $10 is worth more when the current price of the underlying security is $20 than when it is at $10 or at $5
  • Length of time to the option’s expiration date: The longer an option lasts, the higher its value. This is because there is more time available for changes in the value of the underlying security to move in ways that are favorable relative to the strike price
  • Price volatility of the underlying security: The more volatile the pricing of a security, the higher the value of an option on that security. This is because higher volatility means a higher probability of larger price moves between the strike price and the underlying security’s price
  • Risk-free interest rate: The higher the risk-free rate, the higher the value of a call option. This is because the present value of the strike price is lower as the higher interest rate leads to a larger time-value discount. The opposite holds for put options where the value of the option decreases due to a lower present value of the strike price
  • Dividend rate of the stock: A higher dividend rate makes call options less valuable. Dividends reduce the enterprise value of a stock (which is reflected in a lower stock price commensurate with the level of dividend) so larger dividends should mean the stock price decreases at a higher rate

Pricing options can be pretty complicated, so I use the following simple rules of thumb to get a feel for what an option’s price should be:

  • The further away the expiration date, the more costly the option will be
  • The more volatile a stock, the costlier the option
  • As interest rates rise, call options get more expensive and puts get cheaper

How are options used and what roles can they play in a portfolio?

Options are generally used by more sophisticated investors. There are three main ways that they are used which are available to retail investors.

  • Hedging risk: Options were originally developed to hedge risk across a range of assets. A simple example is a company which produces oil or natural gas. They have a pretty good knowledge of the amount of that fuel they are going to produce in the future. To improve their revenue visibility, they may purchase a put option which gives them some certainty in revenue for a commodity which has very volatile pricing. If the price of their commodity decreases below the strike price, they have a guaranteed price from the put option with their realized net price equal to the strike price of the option minus the premium and any transaction costs. If the price doesn’t decrease, they let the option expire and lose just the premium paid and transaction costs. On the flip side, a heavy user of oil and gas such as a trucking company may want to lock in their fuel cost today by purchasing a call option. If the price of fuel increases, they have the ability to buy at the strike price of the call option with their net price equal to the strike plus premium plus transaction costs. If the price decreases, they let the option expire with a loss of the cost of the premium and transaction costs. This usage of options is like buying price insurance
  • Speculating in a levered manner with limited downside: Because options are priced at a fraction of the underlying security, they allow speculators who want to make bets on price movement the ability to do so in a levered manner. As an example, if you believe that stock X is going to go up significantly from its current price of $10, you can buy an $11 call option for a premium of a $150 (note: this is a made up number for example purposes). This option gives you the right to buy 100 shares at $11 up to the option expiration. If the stock goes up to $15.50, you exercise the option and get back $450 for a profit of $300 ($15.50 stock price minus $11 strike price times 100 shares). In this example, your $150 tripled. If you had just bought the stock for $10 with your $150 principal, you would have had 15 shares, each with a $4.50 profit for a total profit of $67.50. By using the option, you were able to multiply your percentage profit by fourfold. Now, if the stock’s price stayed at below $11 up to the expiration date, you would lose your $150 premium as the option expires worthless. Utilizing options in this manner has a limited downside as it is capped at the premium plus any transaction costs
  • Improving entry and exit points for an investment with covered puts or calls: Investors who are planning to buy a security or sell one that they already own can utilize options to potentially improve the entry and exit points. For example, if you want to buy stock X which is at $10 today, but your price target to purchase is at $9, you can sell a put option with a $9 strike price and collect the premium minus transaction costs. If the stock goes below $9 by the expiration date, you are obligated to buy it at $9. If the stock doesn’t fall to $9, the option expires and you keep the premium. Now, in order to sell the put, brokers will require you to have the $900 ($9 strike price x 100 shares) in your brokerage account in case the option is exercised, hence the name covered put. This mean you need to have capital to be able to sell put options. From a risk and reward perspective, you risk having to buy at the $9 even if the stock falls much lower. However, if $9 was your target price to purchase, you probably would have bought that stock at that price anyway, so this is less of an issue from my perspective. The reward is the premium you got by selling the option. On the flip side, if you already own a stock that you want to sell, you can sell a covered call at your target sales price which enables you to collect a premium. In order to be a covered call, you would need to already own the stock and hold it through the option expiration. If the stock price increases beyond the strike price, you get that strike price as well as keeping the premium for a higher net price than your original target. Now, of course, this means you lose out on any additional stock price appreciation beyond the strike price. If the stock price does not increase to the strike price, you keep the premium, but you lose out on the opportunity to sell the stock. This is the only way I use options and I will write a couple of articles in the coming days to provide more detail on this options strategy

While retail investors are able to utilize options in each of the manners above, I would recommend being conservative and focusing on only the third one. Remember that options pricing is done by sophisticated financial institutions and, whenever there is an asymmetry in information or knowledge, the edge is with the party which has greater information. The premiums that you pay are priced to be profitable for your counterparty, which limits your upside.

This completes today’s post on What is an Option and How are They Used in Investing. The practical steps you can start taking from today’s post are:

  • Take some time to learn about how options work and how they are priced: Like any financial instrument, they have intricacies in how they work, are priced and the valid place they can play in your portfolio.
  • Determine how you would want to use options in your portfolio: There are three main ways to use options. Determine which, if any, make sense for you and your unique investing circumstances. Each of these uses has pluses and minuses. For me, the only usage that fits in my portfolio is to sell covered options to further improve my entry and exit points of an investment I already plan to enter or have. I do not speculate with options as it is fairly easy to lose money on them given that the counterparties are sophisticated investors. I plan to write several articles shortly to show how I use options so please keep your eyes open for them.
  • If and when you do add options to your investment mix, make sure to start slow with small dollar values and cap your exposure in case the option does not work out the way you want: Remember that there is a lot of leverage embedded in options which can have a large negative impact if you make a “bet” that doesn’t work out.
  • Please also note that I am not a financial advisor and I am sharing what we are doing with our investment mix for information purposes only: Do your own due diligence before you make any investment decisions.

Thank you for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected].

stockspersonal financeinvestingadvice
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About the Creator

Sudhir Sahay

Sudhir Sahay is a Sales and Marketing executive and a father of two young men. Sudhir hopes to share his journey building basic financial literacy for his children and providing savings and investing advice to their friends and peers.

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