In the spirit of exposing the Investing Decoded world to new ideas and methods of investing, today I’d like to talk about options. If learning to buy stocks was like getting a bachelor’s degree, options trading is like getting a master’s. There’s a whole new layer of complexity associated with options that change the entire risk/reward profile of the instrument. In fact, I would advise most new investors to stay away from options. But at the same time, options can contain valuable information about a stock that you may already own or are thinking about buying.
What Is an Option?
Imagine that you’re looking into buying a stock (let’s just say GE for example). You’ve read all those awesome InvestingDecoded articles and have done your homework on GE. After all that, you’ve decide that GE should be up 10% by the end of the year. But there’s one slight problem, you don’t have the money to buy a significant amount of stock. Not to worry – all you have to do is take the money you have and buy a ‘call’ option for GE. The option will allow you to take advantage of upside (or downside if you buy what’s known as a ‘put’ option).
Conceptually an option is pretty simple – it’s a contract that give you the right – but not the obligation – to buy (call option) or sell (put option) a stock at a pre-determined price (the strike price). In our GE example, since you think the stock is going to go up by 10% by the end of the year, you can buy a call option that gives you the right to buy the stock.
Here’s the catch, though. Like most contracts, options eventually expire. So the option might give you the right to buy the stock at a certain price, but you will also have to ‘exercise’ that option by a certain date.
At this point you might be thoroughly confused, so let’s go through an example. Say you want to buy the GE stock because you think it’ll go up 10% to approx $17 by the end of the year, but you only have $100 to invest (not really enough to make a big impact). Instead of buying the stock itself, you start looking into buying call options for GE stock. Just like stocks, you can pull up a quote for GE options (they’re known as option chains). This option chain will show you what the various option contracts (various strike price/expiration data combinations) are trading at.
Looking at the GE option chain you can see that the December 17 Call options (meaning options that expire in December and have a $17 strike price) are trading at $0.50 per contract. This means that you can reserve the right to buy 100 shares of the stock for $17 at the 3rd Friday of December (options contracts generally expire on the 3rd Friday of the month and trade at 100 share increments).
So let’s say you buy a December 17 contract for GE while the stock is trading its current price of approx $14.50. As the third Friday of December approaches, if the stock is trading below $14.50 the option will likely also be worth closer and closer to $0 – until the actual expiry date, at which point it expires worthless. If you had bought the option, you would’ve lost exactly $0.50 – nothing more.
If the stock goes up as December approaches, the option will also trade higher. If the stock trades around $19, then you could expect the stock to trade more like $0.70 – that’s a 40% jump! You can then trade out of the option (sell the contract to someone else) and run. OR, you can wait until the option expires. Assuming the stock is still trading at $19, you’ll have the right to buy the stock at $17 and can then immediately turn around and sell it.
How Options Are Useful
As you can probably see by now, options can be somewhat complicated. That’s why I suggest that if you’re not wholly comfortable with them. To be honest, I tend to stay away from them myself. There are a few serious risks you should understand about them before you try your hand at them:
- When you buy an option, all you do is own a contract – not a real asset. The contract is merely a piece of paper with an implied value. This is different from a stock where you actually own a piece of the company (a hard asset) and the dividend and voting rights that go along with them.
- Options are used by a leveraging mechanism – they multiply the effect of a stock’s movement. This means that you can get into real dangerous situations if the stock goes the opposite way from where you expect. If the stock goes below the strike price of the call option, the option will be worthless and you'll lose 100% of your money.
But All’s Not Lost!
Even if you don’t invest in options, you can still benefit from them. This is because options can give you really good insights as to where the stock of the option is headed. For example, if on a given day there’s heavy buying for call options for a given strike/date combination, that indicates that investors are betting the stock will be going up by that date. It might be a risky bet because if it was really going up, many of the investors would probably actually buy the stock. But as an equity investor, you can look at the options of the company as a sort of barometer for where the stock is headed.
Recently I bought Ford stock (F). Since then the following article came out about a bullish sentiment on the stock based on its option activity. This is a great example of how options trading impacts the actual stocks and you, as an individual investor who doesn’t directly invest in options, can benefit!
Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!
The Standard Disclaimer:
The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.
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