Options Trading: An Investment Worth Your Time
In the movie Trading Places, Eddie Murphy famously brands two uber-well-to-do commodity brokers as a "couple of bookies." It's a humorously unbecoming label but not altogether untrue, and it wouldn't be a stretch to similarly label their clientele as a mere gaggle of gamblers.
The advent of online brokerage houses has given part-time and hobbyist investors an unprecedented level of access to financial markets and instruments. For as little as 5 bucks, anyone with some disposable income can place their bet on the future fortune of any publicly-traded company by purchasing shares of its common stock.
Stock shares, in essence, entitle their owners to a certain portion of the company's future profits. Some companies choose to reinvest all of their profits in the pursuit of growth, while others disburse at least a portion to their shareholders in the form of dividends. The key to making money in stocks is to identify and invest in companies that are likely to increase their profits moving forward.
The savvy, logical, and impatient among us have already noticed a few limitations here. What if I don't have enough cash to put away for months or, potentially, years? What if I think the company is likely to do better but still faces a few critical hurdles? What if I'm almost certain that the company is going to fail? Shouldn't there be a way to profit in that instance as well?
Enter the fascinating, quick-moving, and extremely volatile world of "options" or "derivative" investing. Despite their relatively simple premise, few people without formal financial education understand options trading well enough to deal in them confidently. Options are perceived as hopelessly complex and even vilified as evil mechanisms that can bring the global economy crashing down. In truth, options can be a complementary or altogether superior investment to stocks. They can enhance dividends, increase profit potential, limit losses, lower the amount required for investment, and provide a means to bet on decreasing share prices.
What Are They and How Do They Work?
Options are sometimes called "derivatives" because their value is "derived" from the value of a particular stock to which they are tied. Since the value of the stock can only go 2 directions (up or down), there are only 2 types of options: the "call" and the "put." Every fancy, advanced strategy results from buying or selling combinations of calls and puts.
For simplicity, let's stick to the buy side for now.
If you believe the stock will go up, you purchase a "call" option. Think of it this way: a "call" gives you the right, at a determined point in the future, to "call" a share of stock away from someone who currently owns it. If you decide you want it, that person is obligated to sell it to you.
If you believe the stock will go down, you purchase a "put" option. A "put" gives you the right, at a determined point in the future, to "put" a share in someone else's hands. If you decide to sell the share, that person is obligated to buy it from you.
To see how each works, let's look at an example. You've been watching Old McDonald industries (ticker: EIEIO) on the stock market. Its shares currently trade for $10 each, and both call and put options cost 50 cents.
In the "call" scenario, you believe the stock price will be higher 3 months from now. You purchase a call option at $10 for a price of 50 cents, and 3 months later, the stock has actually increased to $15. Good for you. The person who sold you your call option is obligated to sell you the share of stock for $10 even though its current value is $15. You "exercise" your option to buy the share for $10, and you can sell it immediately on the open market for $15. You've made $5 on the stock, and all it cost you was the 50 cent price of the option.
In the "put" scenario, you believe the stock price will be lower 3 months from now. You purchase a put option at $10 for the price of 50 cents, and 3 months later, the stock has actually decreased to $5. Again, good for you. The person who sold you your put option is obligated to buy a share of stock from you for $10. You don't have a share to sell him at the moment, but you can buy one right then for $5 on the open market and exercise your option to sell it for $10. You've made $5 on the stock, and all it cost you was the 50 cent price of the option.
The Black
Well wait, you say, why would I want to buy the call option? Why wouldn't I just buy the stock if I think it's going up? I would have made $5 on it either way, and I wouldn't have had to spend 50 cents on the option.
Here we can see two simple ways that options may be the better buy.
1. Options limit your potential for loss.
You bought Old McDonald stock for $10 thinking it was going to go up, but imagine that instead it dropped considerably all the way to $1.
At that point, you would have lost 9 of your original $10. Ouch.
Instead, imagine that you had bought a call option at $10. The stock fell to $1 over the next 3 months, but luckily, you didn't own it. All you owned was the right (but not the obligation) to purchase it for $10. You would obviously choose not to exercise that right.
At that point, the option "expires unexercised," and you lose the 50 cents you paid for it. It's not an ideal scenario, but far from the catastrophic 90% loss you would have taken on the stock.
This is a key feature: when you buy an option, your maximum loss is the price you paid for that option. Your worst-case scenario is that the option will expire unexercised.
2. Options let you multiply your money for greater earnings potential
If you had bought the share of stock for $10, the $10 would have been spent and remained gone until you sold the share. With options, the only money spent up-front is the price of the contract.
Let's say you're extremely, extremely sure that Old McDonald will go up in price. You take your $10, buy 18 options for 50 cents each ($9 in total), and put $1 in the bank.
Again the stock price falls to $1, and again you let your options "expire unexercised." At that point, you would have lost the $9 you spent on the options. Sound familiar? Yep, it's the exact same loss you would have incurred had you bought the stock.
But if the stock price rises to $15, as you suspected, you would own the right to purchase 18 shares for $10 each. This is a $5 profit per share, times 18 shares! You've turned your $9 investment into $90 for a tidy 1000% profit, and you've got that extra buck in the bank to boot. You do an awkward dance, take your significant other out to dinner, and talk all about how wonderful you truly are.
The Red
To present a balanced perspective, any investment that has the potential for greater earnings has the potential for greater losses, and options are no exception.
Looking at the multiplying example above, what would happen if Old McDonald's stock did not drop by such a dramatic amount. Say instead that the price dropped from $10 to $9 after 3 months.
If you had spent $10 on the share of stock, you would have lost only $1, and there would still be potential for the stock to rise again in the future.
If you had spent $9 on 18 call options and put $1 in the bank, you would be hurting. Since the stock price was below the $10 threshold (even though it was not by much), you would still be unwise to exercise the options. There'd be no reason to pay $10 for a share that could be bought for less. The options would expire worthless and you would lose the $9 you spent on the calls. It's a highly aggressive, all-in strategy that should be attempted only with money you're comfortable losing.
Next Time
In part 2, I'll describe the sell side of options contracts and present some basic trading strategies including the "covered call" and "protective put." I'll also briefly discuss options valuation, the determinants of price, and 2 noble Nobel winners named Black and Scholes.
