In the world of investing, there are a lot of securities in which you can invest your money: stocks, bonds, commodities, mutual funds, futures, options, and more. Most investors stick with mutual funds. Of course, there is a fee, but it takes all the management worries away. Many will invest in stocks and bonds to try to capture larger gains. And some will invest in options. Options trading can be an excellent way to increase your net worth if you do it right.
- An options contract is an arrangement between two parties that grant rights to buy or sell an asset at a particular time in the future for a particular price.
- The intended reason that companies or investors use options contracts is as a hedge to offset or reduce their risk exposures and limit themselves from fluctuations in price.
- Because options traders can also use options to speculate on price or to sell insurance to hedgers, they can be risky if used in those ways.
What Are Options?
Options are contracts that give you the right, but not the obligation, to buy or sell a security. In essence, you purchase the option to buy (or sell) the security.
For example, let’s suppose you want to buy 100,000 shares of XYZ stock for $5 per share. But either you don’t have the money at the moment to buy that much, or you are nervous that the price may drop. So you purchase the option to buy at $5 per share for $5,000. Now you can legally buy XYZ stock for $5 per share, no matter what the share price does; the contract lasts about a month.
Suppose a few days later, XYZ Company releases better than expected earnings and says that they have invented a machine that will solve world hunger. Overnight the stock shoots from $5 per share to $50 per share. You exercise your option and you spend $500,000 to buy $5,000,000 worth of the stock. You turn around and sell it for a $4,495,000 profit ($5 million - $500,000 - $5,000).
Now let’s suppose the opposite happens. XYZ Company declares bankruptcy and goes under. The stock drops from $5 per share to $0. You can let your option expire worthless, and you are only out the $5,000.
That’s the easy part. The confusing part is that there are more options than just the option to buy. You can take four positions when trading options. You can:
- Buy a call: This was our example above, you buy the option to buy at a specific price in the future.
- Sell a call: This is when you sell the right (option) for someone else to buy the underlying at a specific price in the future.
- Buy a put: This gives you the option to sell the underlying at a specific price in the future..
- Sell a put: This is when you sell the option to someone else to sell the underlying at a specific price in the future.
Confused? It’s okay, there’s a lot that goes into it. If you buy a call, or you buy a put, your maximum loss is the premium that you paid, and you’re under no obligation to buy or sell. If you sell a call or sell a put, then your maximum gain is the premium, and you must sell if the buyer exercises their option.
Is Options Trading Risky?
Now that we know what options trading is, let's take a look at the risk behind it. The issue, however, is that not all options carry the same risk. If you are the writer (seller) you have a different risk than if you are the holder (buyer).
Call holders: If you buy a call, you are buying the right to purchase the stock at a specific price. The upside potential is unlimited, and the downside potential is the premium that you spent. You want the price to go up a lot so that you can buy it at a lower price.
Put holders: If you buy a put, you are buying the right to sell a stock at a specific price. The upside potential is the difference between the share prices (suppose you buy the right to sell at $5 per share and it drops to $3 per share). The downside potential is the premium that you spent. You want the price to go down a lot so you can sell it at a higher price.
Call writers: If you sell a call, you are selling the right to purchase to someone else. The upside potential is the premium for the option; the downside potential is unlimited. You want the price to stay about the same (or even drop a little) so that whoever buys your call doesn’t exercise the option and force you to sell.
Put writers: If you sell a put, you are selling the right to sell to someone else. The upside potential is the premium for the option, the downside potential is the amount the stock is worth. You want the price to stay above the strike price so that the buyer doesn’t force you to sell at a higher price than the stock is worth.
To simplify further, if you buy an option, your downside potential is the premium that you spent on the option. If you sell a call there is unlimited downside potential; if you sell a put, the downside potential is limited to the value of the stock.
Using Options to Offset Risk
Options contracts were initially conceived as a way to reduce risk through hedging. Let's take a look at a few option strategies that utilize options to protect against risk.
- Covered calls: With covered calls, the individual selling call options already owns an equivalent amount of the underlying security. While a covered call is a relatively simple strategy to utilize, don't dismiss it as useless. It can be used to protect against relatively small price movements ad interim by providing the seller with the proceeds. The risk comes from the fact that in exchange for these proceeds, in particular circumstances, you are giving up at least some of your upside rewards to the buyer.
- Protective put: A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.
Puts by themselves are a bearish strategy where the trader believes the price of the asset will decline in the future. However, a protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.
Protective puts may be placed on stocks, currencies, commodities, and indexes and give some protection to the downside. A protective put acts as an insurance policy by providing downside protection in the event the price of the asset declines.
More complex option spreads can be used to offset particular risks, such as the risk of price movement. These require a bit more calculation than the formerly discussed strategies.
The Bottom Line
So is options trading risky? If you do your research before buying, it is no riskier than trading individual issues of stocks and bonds. In fact, if done the right way, it can be even more lucrative than trading individual issues.
But it all comes down to whether or not you did your research. If the research points to the stock increasing in price soon (hopefully before the option expires), then you can buy a call. If research points to a stock decreasing in price, you can buy a put. If the research points to the option staying about the same, you can sell a call or a put. Remember: you have a lot of options with options.