Options 201

Note: This article is part of a four-part introductory series on understanding equities, options, bonds, and foreign exchange markets.

During the tech bubble of the late 90s when profitless companies surged in value with nothing but a mission statement, the popularity of employee stock options exploded. Why take a fixed $10,000 pay increase when a stock option could increase its value tenfold within a year? Of course, the following years quickly showed how those same options could free-fall in value, but those who understood options still managed to profit regardless of market direction.

In the financial world, an option is simply the contractual right, but not the obligation, to buy or sell an underlying asset at a specific price (called the strike price) before an expiration date. Employee stock options are the right to purchase company stock at a set price before a set date. It may sound confusing, but option-like contracts are also seen in the real world.

For example, imagine that you are taking a class your friend took last semester. He is willing to sell his textbook for $75, but you are not sure if it is the best price so you ask him to hold it for you for two weeks. Of course, he is now taking a risk so he demands a premium of $5 to not sell it to anyone else. A week later, you find out that all the freshmen are taking the course and are paying up to $150, so you go ahead and buy it. While you paid an extra $5 to buy the right to purchase the book, you ended up saving (or profiting if you decide to flip the book to some freshman) $70. However, if the publishers released a new edition of the textbook and the price tanks to $20, you do not have the obligation to buy it (despite what your friend says) and therefore all you lose in that transaction is the $5 premium instead of the $55 difference in prices.

This is similar to how options work in the investing world. Options are contracts that derive their value by the value of the underlying asset, which is why sometimes they are called derivatives. Stock options therefore are contracts that derive their value from the underlying stock. There are two types of options, calls and puts.

Call options are the right to buy an asset at a predetermined price before a predetermined date. There are analogous to going long on a stock, and the value of the option increases as the value of the underlying stock increases.

Put options are the reverse of call options. They give the right to sell an asset at a predetermined price before a predetermined date. They are analogous to shorting a stock, and the value of the option increases as the value of the underlying stock decreases.

On the other end of option buyers are option writers, an writing options are more commonly known as shorting a put or call option. Unlike buyers, writers have the obligation to buy or sell at a predetermined price if the contract gets exercised by the holder. Unlike most other securities, writing options are profitable in a sideways market, but they also entail great deal of risk that needs to be accounted for.

One of the biggest advantage of options over other securities is that they can be profitable regardless of market direction. Speculating on options is difficult since it requires correctly forecasting market direction, magnitude of the move, and timing, but the payoff can be tremendous while the losses are fixed, as shown in the textbook example. Some also use options as a hedge, by limiting the downside to any trade at the price of the option.

Options are complicated securities that require a dedication to understanding the intricacies of pricing, implied risk, and time value, but having options in your investing arsenal can open up a wide range of opportunities for profit unseen in traditional investment vehicles. Even if you are looking to options solely as a hedge, the fixed nature of costs in the form of premiums can greatly simply and enhance any trading strategy.