Options are complex and often intimidating. An asset class just as stocks and bonds, options can prove lucrative if utilized properly. Unfortunately, many investors do not take advantage of them, seeing them as too complicated to really deal with. With some basic knowledge of how this all works, you'll be adding options to your portfolio with ease in no time.
Some of the best traders and investors are active in the options market. By joining them and incorporating options into your portfolio, you can be well on the way to lucrative financial opportunities.
Options: A Primer
Options aren't the most thrilling. What they are is a great way to build towards retirement and have increased access to money for travel or other ventures. Why is that? Because when traded strategically they can result in outstanding rewards. This is much due to the various advantages and protections that come with them.
Options are based on speculation and are part of the derivatives umbrella of securities. They allow investors to buy a contract that allows them to buy or sell a security within a set timeframe. They are not a direct investment in a company but rather an investment in the direction of a stock. In these instances, investors are positioning themselves for the future based on speculations about how a security will perform in the future. When they see the option as most lucrative, they will exercise their contract and, at least most of the time, immediately trade the security.
This makes options trading great for those who are active in their buying and selling of stocks. These investors do not look for shares in a company but rather speculate about how much shares will be worth at a particular point in time.
There are two types of options. Call options are where an investor buys a contract that will allow them to buy a security at a later date for an agreed upon price at the start of the contract.
Pull options are where an investor buys a contract that will allow them to sell a security at a later date for a price agreed upon at the start of the contract. The goal of each is to buy an option at an advantageous point in regard to future speculation about how a security will perform.
Call Options: A Closer Look
Call options are those where traders buy a contract to buy a stock at a particular price within a set timeframe. The goal of most investors who buy call options is to purchase a contract when a stock is offered low and when they think the price will increase in a particular time frame.
If and when it does increase to a desired level, investors will exercise their option, buying the security and often immediately selling it at a desired, higher price.
Let's run through a quick example.
Stock X currently trades at $42. A savvy investor thinks that stock will increase to $80 within the next six months. Not wanting to risk too much speculation, the investor opens a call option. Their contract allows them to purchase the stock at $45 within six months. In four months Stock X reaches $75.
The investor no longer thinks it will reach $80 and that $75 is a high point. The buyer exercises their options contract to purchase the stock at $45, immediately selling all shares for $75 and banking $30 profit per share. They can also cut out the middle-man and sell the call option, instead receiving the $30 profit per share immediately.
With the above example it may seem as if options are a superior, more secure way of trading. For those not interested in actively owning shares in a company, they definitely can be! Their risk, however, comes in the premium attached to buying an options contract.
A premium is essentially a non-refundable down payment. It is assessed when an option is purchased. If a contract expires without a buyer exercising an option, the premium is lost, and the buyer, at least in this instance, would lose.
The Deal with Put Options
On the opposite end of call options are put options. Put options are somewhat like an insurance policy. They allow those who buy a put option to sell a security for a set price within a particular time frame. The hope in this case is that a security falls in price during the contract timeframe. What difference there is between the stock price and put option will be the profit, minus the premium.
Put options are sometimes seen as more complicated, but they do not have to be.
The first thing to understand is that to purchase a put you must first own a share. That's why comparing puts to insurance is so common. When you own a share there is always the risk of a stock falling. To mitigate the risk of a substantial loss, investors purchase put options. This lets them sell the stock at a contract price in a particular time frame, no matter how far a stock falls. Even if a stock completely crashes and falls to zero, a put buyer will be able to recover the difference between 0 and their strike price.
Let's run through another quick example.
An investor owns one share of Stock X, which is currently trading at $500. This investor is cautious, however, and sees a bear market ahead. To protect against uncertainty, they buy a put option to be able to sell the stock at $475 any time in the next 6 months.
Within four months the stock market crashes, and Stock X drops to $300 per share. At this point the investor exercises the strike price of $475 and is able to sell their shares at $475 instead of the market $300, recovering $175. The ‘profit' will be $175 minus whatever premium associated.
You've Got Options
Options are not as complicated as many make them out to be. As with all things investing, all you need to do is take the time and effort to read through and understand them. Some of the best traders and investors are active in the options market. By joining them and incorporating options into your portfolio, you can be well on the way to lucrative financial opportunities.