Options get a bad rap.
Investors think options strategies are too complicated. Or risky. Or temperamental.
Maybe it’s the terminology that is off-putting. Complex option structures like straddles, strangles, and spreads can make your head spin. Even most savvy investors don’t totally understand all the moving parts involved in these option trading strategies and the risk-reward balance.
However, in a market where investors want to protect against fluctuations in price, manage risk within their portfolios, and increase returns, options can be a valuable tool.
Rapid changes in price are what everyone has their eye on. And it can make a huge difference in price, both in the price of the stock and in the current price of the option.
But once you know how to manage the risky piece of trading options, the reward in that risk-reward balance can be massive.
And the truth is, you only need to understand a few basic concepts in order to demystify option trading strategies. In this article, you’ll learn what options are and examine call vs. put options. You’ll also learn why incorporating options into a strategic investment plan is becoming popular.
Demystifying Options
Any diversified investment portfolio typically includes several asset classes: stocks, bonds, ETFs, mutual funds, etc. Options simply represent another class of assets that can provide certain benefits and rewards that the other classes can’t.
The technical definition of an option is: a contract that provides the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price — the “strike price” — on or before a certain “expiry” date.
In other words, when an investor buys an option, he or she buys a contract that provides the right to buy or sell an underlying asset at a certain predetermined price at some point in the future before that contract expires.
Let’s unpack that a bit.
Underlying Assets
The logical place to begin is the underlying asset, sometimes also referred to as the underlying investment. The underlying asset, in many cases, will be stock.
Investors often speculate on the direction the stock market will take. So they will use options contracts to “bet” on whether the stock (the underlying investment) is going to rise or fall in the future.
While many options contracts involve stock or underlying shares, the underlying asset can really be anything.
For example, imagine an investor sees a housing development under construction, but only wants to buy one of the homes when the development is complete. That investor would purchase an option to buy the home at, say, $1 million by the end of next year. Even if demand — and the value of the underlying asset — goes through the roof and prices skyrocket to $1.4 million, that investor has the right to buy the home for $1 million.
In this example, as long as the investor purchased the option for less than $400,000, the option contract would be a profitable investment.
Contracts Provide Rights, Not Obligations
Because options are a contract, there is a buyer and a seller. The buyer is the option holder, and the seller is the option writer.
The holder of the option has the right to buy or sell. But it’s important to note that the option holder has no obligation to buy or sell.
If the option holder does nothing, the option — or the right to buy or sell — loses all intrinsic value and simply expires.
Call and Put Options
There are various types of options available to investors. The most common types of options are call options and put options.
When the option is to buy stock, it’s called a call option. So if an investor buys a call option for XYZ Company stock with a strike price of $10. This means that the investor expects the price to rise above $10 before the option expires.
When the option is to sell shares of stock, it’s a put option. So if an investor buys a put option for XYZ Company stock with a strike price of $10. This means that the investor expects the price to drop below $10 before the option expires.
Let’s look at an example of how this might work with a call option.
Imagine you think you’ve found the next Tesla stock, so you buy a call option. As the option holder, you’re indicating you expect the market value to rise. You pay a premium in order to purchase the option contract. On the other hand, the option writer is betting that the market will remain flat or dip.
If your expectation is incorrect, you would simply not exercise the right to use it. You would let the option expire, and the writer can walk away, pocketing the premium.
And this happens more than beginner options traders might think. Ninety percent of the time, in fact, that’s exactly what happens.
How Can Options Complement an Investment Portfolio?
Once considered a strategy reserved only for professional and seasoned financiers, options contracts are now something many individual investors have adopted.
In fact, CNBC recently dubbed options trading “the new sports betting.”
After all, options are really just another tool to add to your arsenal when building a comprehensive investing portfolio.
Options can help generate income and protect investors from a market sell-off. The key word here, however, is “can.” Of course, options contracts come with a margin of risk and that risk increases if you don’t know what you’re doing.
Understanding Implied Volatility
When trading options, an important concept to get a handle on is implied volatility. Market prices fluctuate, and investors have long been trying to predict price movement — whether a stock’s price will go up or down. Implied volatility is an effort to predict exactly that.
It represents the expected amount of up and down activity in the stock price over the life of the option.
When you buy an options contract, you can protect against predictions that go awry. And the price of the option is going to be much less than if you bought shares of the underlying stock outright. This is because you’re not actually buying the stock but the right to buy that stock.
The more the price is expected to fluctuate, the higher the implied volatility. And when implied volatility rises, so does the price of the option.
Using Calls To Hedge Against Price Drops
With call options, you can increase profits dramatically without adding more risk.
For example, imagine you purchased 100 shares of XYZ Company stock at $50 per share — a total of $5,000.
You thought about buying more but were worried about investing too heavily in XYZ.
So instead, you purchase call options to buy 100 more shares at $50 per share. For these call options, you paid 30 cents per share, or $300 total.
A month later, before the expiration date, XYZ skyrockets to $65 per share. You get to buy the stock at $50 and enjoy a $1,500 gain for a mere $300.
If XYZ stock had plummeted, you wouldn’t have taken a loss. Instead, you’d simply let the options expire.
Using Puts To Hedge Against Losses
With put options, you can hedge against losses from stock price declines.
For example, imagine you purchased 100 shares of XYZ stock at $50 per share, or a total of $5,000.
Then, you also purchase put options to sell XYZ at $50 per share. Imagine the put options are 20 cents per share. So now, you pay $200 to cover 100 shares.
If the stock price on XYZ dips to $40 before your options expire, that would be a $10 per share drop. If you were to sell your 100 shares at the $40 price, you’d be losing $1,000 on your investment ($10 times 100 shares).
Instead, you can exercise your option and sell your shares for $50 per share. The put options acted like $200 of insurance to protect you from losing $1,000.
Seeking Advice About Call vs. Put Options
Incorporating options contracts into your investment strategy is really a game of speculation. If you’re an investor who believes that the price of a stock will move in a certain direction and you’re positioned to accept the potential risk, you can reap substantial returns.
You have extra cash sitting around the house, and you’re ready to add options to your portfolio. But how do you find hot trades — like TSLA challenger NIO that was upgraded by JPMorgan in the fall?
Subscribe to Investors Alley’s “Options Floor Trader PRO” newsletter and we’ll show you how to find and make those trades.
