Options have a bad reputation among investors because many people have lost significant amounts of money when speculating with options. Even the Oracle of Omaha, Warren Buffett, warns about the dangers of options and refers to them as financial weapons of mass destruction. But the reality is that options are not inherently good or bad for an investor. It all depends on how they are used.
Investors use options for many different reasons. Some use options to preserve capital by hedging, while others seek high returns through speculation. Many of the strategies that include options are complex and inappropriate for most investors and beginners should stay far away from this area of the market that includes options and other derivatives.
What are options?
In today’s market, there are two main types of options. Call options and put options. Call options give the owner of the option the right to buy stock at an agreed upon price before the option expires on a predetermined date. Put options are the opposite and gives the owner of the option the right to sell stock. There are also a few varieties of options that only allow the owner of the option to use it on specific days. It’s important to read the fine print and understand what an investor is getting into with options.
Here is a hypothetical example to show how options might work.
Imagine that company XYZ is currently trading at $58 per share and an investor wants to buy a call option with the right to buy the stock at $60 within 6 months. To gain the privilege of buying company XYZ at $60 within 6 months, the investor needs to find someone else who is willing to take the other side of the trade. Usually this involves the payment of a premium. In our example, let’s use a premium payment of $2.50. Since the buyer of the call option paid $2.50 to buy the stock at $60, the stock needs to rise above $62.50 for the investor to make a profit.
Why does the investor use options that won’t become profitable until the stock reaches $62.50 instead of buying the stock today at $58? There can be several different reasons, but usually it’s because of leverage. Each option contract is for 100 shares so the $2.50 contract would cost the investor $250 in premiums, but if the investor were to buy 100 shares of the stock at $58, they would need $5,800.
The hard part when it comes to options is that the investor needs to get the timing right in addition to being right about the movement in the underlying stock price. If the stock price doesn’t go up enough before the option expires, the option becomes worthless. After all, why would anyone buy a stock for $60 a share if it’s available on the market for less?
However, if the stock goes up in time, the return from options is much greater than the return from buying the stock outright because of the inherent leverage in options. For example, if the stock reaches $70 before the option expires, the option might be worth $10 or a 400% return on the option even though the stock only increased by 21% ($58 original stock price).
Instead of buying options and paying a premium, investors can also sell options and collect the premiums. Selling options comes with obligations that the investor must meet. If the investor sells a call option, they have to deliver the stock to the buyer of the option if the buyer exercises their right to do so. If the investor sells a put option, they must be ready to buy the stock at the predetermined price from the buyer of the put option and make sure they can meet the obligations of the contract.
Some investors sell put options as a way to generate income from premiums on stocks that they like, but are currently trading at a price that is too high for them. For example, a stock that an investor likes might be trading at $90 a share. Although the investor likes the stock, the valuation is a little too rich so they sell put options. Instead of paying a premium to buy the option, the investor collects the premium when they sell the option. For example a put option to sell the stock at $80 a share within 6 months might have a premium of $1.50. The investor collects $150 in premiums for 100 shares. If the stock price stays the same or goes up after 6 months, the put option expires worthless and the investor pockets the $150, but might have missed out on gains if they bought the stock instead. If the stock drops below $80 to something like $75, the investor buys the shares at a cost of $78.50 ($80.00 – $1.50). The investor faces a loss, but it is less than the loss they would have incurred if they only bought the stock.
Options for hedging
An investor can also use options to hedge their current positions. This is like buying insurance for their own portfolio. For example, an investor might own 100 shares of a stock that is currently at $105 a share. They can purchase a put option that gives them the right to sell the stock for $100. If the stock falls, the investor can sell their shares for $100 because of the put option, thus protecting their portfolio for the price of the premiums paid. Ongoing protection with put options can become expensive so investors need to determine if the costs are worth it.
Options are complex financial instruments and investors should use them with caution. Although options can be dangerous if used for speculation, they can also be used to hedge and protect a portfolio. Most investors should stay away from using options speculatively like the buyer of the call option in our example even though the returns can look enticing.
Note: The pricing of an option is based on many factors and involve complex formulas. Our examples simplify the mathematics for calculating the value of an option and may not accurately depict real life situations. There are many books that go into the details of pricing options that investors should look at if they want to use options.