Many people associate financial options with options traders who make mammoth returns on their investment. In reality, options are a useful type of financial security, which is a tradable financial asset such as a stock, that provides traders with flexibility, efficient bets, and most notably, high returns on investment if used correctly.
So, what really are options? Options are contracts that give the buyer the right, but not the obligation, to either buy or sell a quantity of an underlying asset at a specific price at or before the contract expires. They are a powerful tool that can strengthen an investor’s portfolio due to its flexible nature, which allows for additional income, protection, and leverage within a portfolio.
Options belong to a group of securities known as derivatives. They are named as such as the price of a derivative is derived from the price of an underlying asset. Examples of derivatives include futures, forwards, swaps, and mortgage-backed securities. Because they are derivatives, options differ from stocks as an options contract doesn’t represent ownership or equity within a company.
The Options Market
Options trade as contracts, and the term “option” refers to this option contract. This means that they have their own independent market, in which there are mainly two types of options: calls and puts. Call options give the holder the right to buy an asset (typically a stock) at the strike price on or before some specified expiration date. Put options on the other hand give the holder the right to sell an asset (i.e. shares) at the strike price on or before the expiration date. The strike price is the agreed upon price of the underlying asset the buyer of the option either will buy or sell the asset for.
The right to buy or sell an asset at a strike isn’t free. In fact, the price of this “right” is the price of the option, or premium. The premium represents the compensation the buyer must pay for the right to exercise the option, or put into effect the right to buy or sell the underlying asset if the option becomes profitable. Thus, options are similar to insurance, as you pay a premium to gain exposure to an event that pays off. In the case of an options contract, this event is the option being profitable. Consequently, investors must take into account the premium when investing in options as it affects the profitability of the investment.
Let’s look at an example. Let’s say you buy a call option on AMD for a strike price of $60 and an expiration one month from the day you bought it. This means that you have the right to buy a certain amount of AMD’s stock for $60. You would buy this option if you think that AMD stock is going to rise above 60 dollars plus the premium cost. This produces a profit as you would be able to buy the shares for $60 and simultaneously sell the shares at the market price, which is above that strike price while also taking into account the premium of the contract.
It is important to note that the option contract will only be exercisable if the stock’s market price reaches or exceeds the strike price. Otherwise, if the market price never reaches the strike price before the expiration date, it is left unexercised, simply expiring and no longer having value.
Furthermore, buying call options is a bullish, or optimistic, bet on an asset’s future price. This is because the buyer makes money only when the underlying asset’s price goes up.
If the call option mentioned previously was instead a put, the buyer of the put on AMD with an exercise price of $60 entitles the buyer to sell AMD stock at the price of $60 at any time before the expiration date one month from now, even if the market price is less than $60. You would essentially buy the put option if you believe the price of the stock is going to decrease. This produces a profit on the option if the strike price is higher than the premium and market price combined.
It is important to note that the option contract will only be exercisable if the stock’s market price reaches or falls below the strike price. Otherwise, if the market price never reaches the strike price before the expiration date, it is left unexercised, simply expiring and no longer having value.
Buying put options is a bearish, or pessimistic, bet on an asset’s future price. This is because those who buy put options make money when the underlying asset’s price goes down.
We must also remember that it is possible for an investor to make money on a put without owning the underlying stock. This is a naked put, a strategy where an investor buys the put options without holding a position in the underlying stock or asset. Remember, a put gives you the right to sell a set amount of shares for a certain price. If the price of the underlying stock goes down, then the market price/premium of the put option goes up as it’s more likely to hit the strike price. If you don’t own the underlying shares, then usually you would just sell the put option on the market before it expires.
But, if one chooses to exercise the put option without owning the underlying shares, then they need to get those shares to then sell because those are the terms of the contract. The way they do this is either by borrowing enough money, usually from a margin account, to buy the shares at the market price and then exercising the put contract by immediately selling those shares at the strike price to the other side. Then you return the money you borrowed plus some small amount of interest. Your profit would be the number of shares sold multiplied by the difference between the strike price and market price less the marginal interest and premiums paid.
Essentially, the seller of the put hopes to make a profit by receiving premiums that the buyer of the put options pays. If the put is never exercised (market price remains higher than the strike price), then the sellers of the put gain the premiums in profit as they do not have to buy and sell the stock at strike. Sellers can also produce a profit by selling the option to another investor for a higher premium/option price, and this can continue many times before the option expires.
Writers of Options
Because options are derivatives, they are based on an underlying asset. For options for a certain stock to exist, there must be someone who creates them. This person is the option writer. They serve as the creator of an options contract as well as the initial seller of that option. Without options writers, the options market wouldn’t exist.
In a call option, the seller receives the premium price now as payment against the possibility that they will be required to sell the asset some time later at a strike price lower than the market price of the underlying asset. Essentially, if the call option expires worthless because the strike price remains higher than the market price, the seller receives a profit equal to the premium payment they received when selling the option. Otherwise, their net profit or loss is equal to the premium minus the difference between the value of the stock and the strike price paid for those shares all multiplied by the total number of shares.
Call Seller Profit Formula: P(profit) = (K(premium) - (M(market value) - S(strike price))) * T(total number of shares)
In a put option, the writer receives the premium price now as payment against the possibility that they will be required to buy the asset some time later at a strike price higher than the market price. Similar to the writer of a call option, the writer receives the premium in profits if the owner of the option does not exercise it. This is due to the market price remaining higher than the strike price of the underlying asset. However, if it is exercised, the writer would receive a net profit or loss equal to the premium minus the difference between the strike price paid and market price, all multiplied by the total number of shares.
Put Writer Profit Formula: P(profit) = (K(premium) - (S(strike price) - M(market value))) * T(total number of shares)
Long vs Short
The position an investor takes in an option can represent whether they are long or short on an underlying asset. Buying a call option gives an investor a potential long position. Writing a call option gives an investor a potential short position because they receive the premium if the price of the underlying asset never increases and reaches the strike price. On the other hand, buying a put option gives an investor a potential short position. Writing a put option gives an investor a potential long position because they receive the premium if the price of the underlying asset never decreases and reaches the strike price.
Useful Option Terminology
Options are often classified as either in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM). “In the money” describes an option that, when exercised, would produce profits for its holder. “Out of the money” describes an option that, when exercised, would be unprofitable. “At the money” describes an option where the strike price and asset price are equal. However, it is important to remember that the profit would be negative as the holder would lose the premium.
American, European, and Exotic Options
Within option trading, there is a plethora of different types of options. Vanilla options typically encompass both American options and European options. American options allow the holder to exercise either the right to buy (call) or sell (put) the underlying asset at or before the expiration date. On the other hand, European options allow the exercise of the option only on the expiration date and not before. American options are inherently more valuable as they allow for more flexibility, and are generally more popular than European options. Consequently, premiums are higher for American options because of the ability to exercise before the expiration date.
For more professional traders, there exist exotic options, options which have features making it move complex than vanilla options. Examples of such include Asian options, Bermudan options, knock-out, knock-in, and much more that are too complex for this article.
In conclusion, options are a versatile asset class that can serve multiple purposes for an investor. Options also come in two forms: calls and puts. Calls represent an optimistic sentiment towards an investment (bullish) while puts represent a pessimistic sentiment toward an investment (bearish). Although options can be more complex than other investments, it is vital to consider trading options when constructing a portfolio. It can serve as both a speculation tool as well as a hedge/insurance on other investments.