Fun with Options: The Basics (Part 1)
Expand Your Investment Tool Belt
Options are a powerful, low-risk, low-capital and leveraged way to speculate. That may seem controversial or counterintuitive because options are generally portrayed by the financial media as dangerous. I believe they are simply not as well understood as stocks are. Options are a good addition to your investment tool belt.
Some readers have shared feedback that they don’t know much about options. So I’m going to introduce some Option Basics below. Then I plan to share some Simple Yet Powerful Ideas like:
How to Amplifying Returns with Options?
How to Insure Your Investment Portfolio with Options?
How Options can reduce Your Taxes?
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Option Basics (Simplified!)
I know the below can be a lot to absorb but it is important to understand these fundamentals before we move onto the fun stuff! So please go through it, use it as a reference, and feel free to send me any questions. Let’s get started!
What is an Option?
An option is simply a derivative, meaning it derives its value from something else, in our case, a stock. Just like stocks are traded in the stock market, options are traded in options markets.
There are two types of options: call options and put options.
What is a Call Option and what is a Put Option?
Option contracts are an agreement between a buyer and a seller.
A call option (aka a Call) gives the buyer the right but not the obligation to buy a specific stock at a specific price (the strike price) by a specific date (the expiration date). Think of it as a way to “lock in” a buy price for a stock for a specific amount of time. This means Calls become more valuable if the underlying stock rises in value (and vice versa).
Similarly, a put option (aka a Put) gives the buyer the right but not the obligation to sell a specific stock at a specific price (the strike price) by a specific date (the expiration date). Think of it as a way to “lock in” a sale price for a stock for a specific amount of time. This means Puts become more valuable if the underlying stock falls in value (and vice versa).
Option Fundamentals
Below is an example of the Calls and Puts available for Microsoft stock. Each row tells us the option expiration date for a set of options (and the days until expiration).
Below, I am showing the MSFT options available that expire on Feb 21 2020. The middle column represents the strike price for that specific option expiration date. The Bid and Ask columns are the prices people are willing to pay to buy (bid) or sell (ask) that option at. These prices are based, among other things, on the current MSFT stock price ($158.96/share).
Options are by default 100:1 leveraged. Each stock option contract is “equivalent to controlling” 100 shares of stock. This means that if you wanted to buy one option contract, and its quoted price is $1.20 per contract, then your total cost would be $120 per contract (1 contract x $1.20 per contract x 100 shares per contract). If you were to buy 5 such contracts your total cost will be $600.00 (5 contract x $1.20 per contract x 100 shares per contract).
Profits & Losses on Call Options
Let’s say you bought the MSFT Call Options expiring on Feb 21 2020 with a Strike Price of $170/share for $1.20 per contract ($120).
What would happen to these Call Options on Feb 21 2020 (the expiration date)?
If MSFT Price was $175 on Feb 21 2020
Recall, that as the owner of the $170 Strike call option, you have locked in the ability to buy 100 shares of stock at $170/share. Since the stock is trading at $175, it is trading above the strike price, so it is considered “in-the-money”.
As a result, you could buy 100 shares of MSFT stock at a $5 discount to the actual stock price by exercising your option. (Exercising is simply the process by which the holder of an option converts the option into a stock position). This would result in a $5 gain per share ($500) minus the original cost of the call ($120). That is, $380, a 400% return!
Or you could simply sell your Call option for the same profit. The Call would be worth $5 in this case because it allows the holder to buy the stock at a $5 discount to the actual price. By selling the call, the profit would be the same $3.80 per option ($5 minus our purchase price of $1.20, therefore $380).
If MSFT Price was $165 on Feb 21 2020
If the MSFT stock price was $165, the price would be below our strike price of $170. As a result, no would actually “exercise” their option, because it is cheaper to simply buy the MSFT stock directly in the open market. As a result, our options would be “out-the-money” and worthless and we would have lost 100% of the $1.20 paid for them. As you can see, leverage is a double edged sword.
Profits & Losses on Put Options
Let’s imagine you bought one MSFT Put Option expiring on Feb 21 2020 with a Strike Price of $170/share. Based on the prices shown above, this would cost $1225.
What would happen to these Put Options on Feb 21 2020 (the expiration date)?
If MSFT Price was $175 on Feb 21 2020
Recall, that as the owner of the $170 Strike Put option, you have locked in the ability to sell 100 shares of stock at $170/share. Since the stock is trading above the strike, it is “out-the-money” and worthless. The owner of the Put would never force someone to sell MSFT stock to them for $170 when the market is offering them $175/share.
As a result, the Put options would be worthless and we would have lost 100% of the $1225 paid for them.
If MSFT Price was $125 on Feb 21 2020
In this case, the stock is trading well below the strike, and is “in-the-money”.
Since you own the put, you can exercise the Puts and force someone to sell you 100 shares of MSFT stock for $170/share, for a $45/share profit. Or you could simply sell the Puts which would be worth $45.
In this case, the Puts have gained value, resulting in a profit of $32.75/option ($45 minus $12.25), that is $3275, a 270% return!
If MSFT Price was $165 on Feb 21 2020
In this case, the stock is trading below the strike, and it is “in-the-money” once again.
Since you own the put, you can exercise the Puts and force someone to sell you 100 shares of MSFT stock for $170/share, for a $5/share surplus. As a result, the Puts would be worth $5 each.
Note however, the stock price has actually increased from the moment the Put was purchased (when we bought the Put, the MSFT Stock was $158.96/share). As a result, the Put became less valuable. Meaning, although they are worth $5, they actually lost money (since they were worth $12.25 at purchase).
This means the total loss was $7.25 (i.e $725), a 60% loss!
In Conclusion
We have only scratched the surface but the above should provide a good start.
As you can see, options are a powerful high leverage way to speculate. When the leverage works in your favor, the returns can be fabulous. On the other hand, leverage can also be dangerous. But if one understands the risk-reward trade-offs up front, options can be a wonderful part of your investment tool belt.
We will discuss some of these risks and tradeoffs next week.
If anything above is unclear, feel free to send me any questions.
See you next week!