If you have been involved in investing for any time at all then you will be quite familiar with the terms options, puts and calls. However, you might be like the majority of new and/or retail investors that do not really understand what these terms actually mean. Let alone how to implement these investing strategies to help with your overall investment goals. Whether that is to build wealth, generate a greater income, save on taxes, or just play the game. Options might be the answer you are looking for. In this article I will lay out clearly what options are and how you can start implementing them as soon as today. As with learning anything new one must first start with the textbook definition in order to try and grasp the concept at hand.
Option – a financial instrument (an asset that can be traded) that is based on the value of a specific stock or other securities.
OPTION CONTRACTS
This definition is just the tip of the iceberg so to speak. As you actually need an option contract in order to potentially benefit from this type of strategy. An option contract(s) gives the investor, or buyer of the option contract, the option to buy or sell a specific stock or other security (depending on the specifics of the option contract purchased). In essence giving the buyer the right, but not the absolute obligation, to buy or sell the asset if they decide that it is in their best interest to do so. A contract is set up so that a specific type and number of a specified asset are held against a stated price, this price is also known as the strike price. These contracts are only for a specified period and are considered expired at the end of this predetermined period.
PUT OPTION CONTRACTS
There are two types of option contracts, a put option and a call option. Put options are an option contract that gives the buyer the right, not obligation, to sell a specified amount of stock or other securities at a predetermined strike price within a specified amount of time or expiration date. One widely accepted analogy for put options is the insurance analogy. You can loosely think of put options as a type of “insurance” for you stock or other securities. Just as one pays a premium to their insurance companies for the protection of their possessions. One also pays a premium for the protection of their stock or other securities, in this case that would be the purchasing of put options. After you purchase a put option there are two outcomes one can expect. The first scenario, the stock or other securities specified in the put option contract comes to a rest below the strike price at the expiration date. In this scenario the seller of the put option keeps the premium paid by the buyer and is obligated to buy the stock or other securities at the strike price. The buyer of the put option then has the right, but not obligation, to sell the stock or other securities at the strike price. The second scenario is that the stock or other securities comes to a rest above the strike price at the expiration date. In this scenario the put options seller keeps the premium and the put options buyer pays the premium. The only thing exchanged is the initial premium paid to purchase the put options. Put options are limited to their profit potential since assets can only drop to zero, but they do have a minimal loss potential. Since you are only out the “insurance” or premium you paid up front to purchase the put option if the put option expires above the strike price. This premium is usually a very small percentage of the total assets being wagered against.
CALL OPTION CONTRACTS
Call options are an option contract that gives the buyer the right, not obligation, to buy a stock or other securities at a specified price within a specified time period. Call options may be held by the buyer until the expiration date at which they can take delivery of the amount of stock specified in the contract or they can sell their call option contract at any point before this expiration date. If the buyer decides to sell their call option contract before the expiration date the contract will be sold at the current market price of the stock or securities. The premium paid to purchase the call option contract gives the buyer the right to purchase a stock or other securities at the strike price. If the security in question comes to a rest below the strike price, then the maximum sustained loss is just the premium paid and no more. If the security in question comes to rest above the strike price, then the profit is calculated as the difference between the strike price and the current price of the asset minus the premium and then multiplied by the amount of shares specified in the call option contract.
One widely accepted analogy for call options is the layaway or down payment analogy. You can reserve a price on a stock or other securities by buying call options, like a down payment on a large purchase. The call options writer (seller) then sells you the call option contract preserving the price of the asset. Again, like the put option contracts, call option contracts also have two outcomes. The first scenario, the asset in question comes to a rest above the strike price at the expiration date. The call option seller keeps the premium and is obligated to sell the asset in question at the strike price. The call option buyer pays the premium and has the right to buy the asset in question at the strike price. The second scenario, the asset in question comes to a rest below the strike price at the expiration date. The call option seller keeps the premium and the call option buyer pays the premium. The only thing exchanged in this scenario is the premium. Call options are profitable when the asset increases above the strike price by the expiration date. This is because the call option buyer is then allowed to purchase the asset in question at a discounted price (strike price). Call options have a theoretically infinite profit potential and a minimal loss potential. The profit potential is theoretically infinite because the asset can theoretically keep rising in price and the seller of the call option must sell the assets in question at the current market price at the expiration of the call option contract. If the asset’s price is below the strike price, then the buyer is again only out the initial premium paid to reserve the asset at a lower price.
There are two different variances of call options, a long call option and a short call option. A long call option is a call option that allows the buyer to plan ahead to purchase a stock or other securities at a cheaper price. These contracts will usually have an expiration date further in the future and might be correlated to a specific event in the future where the buyer anticipates the asset’s value to increase. An example of this could be an anticipated new product release or a new CEO and/or chair member hire that could cause the price of a company’s stock to rise more than usual. A short call option is essentially the opposite of a long call option. This is where a seller promises to sell their shares at a fixed price in the future, just as a conventional call option. Short call options are typically done while holding a long position in an asset while also selling call options on the same asset (also known as a covered call). This can help the buyer buffer any losses that may be experienced if the trade does not go in their favor.
IMPLEMENTING OPTIONS
Now that you understand the premise of option contracts, your next logical question might be, how do I implement options into my investment strategies in order to benefit me? Options can be used in a variety of ways in order to benefit your portfolio. Of those ways are for increasing your overall income, a way to speculate the market, a way to manage your taxes owed, and to just play the game that is the stock market. One way options can be used to increase your income is through a strategy called covered calls.
The covered calls strategy involves owning an asset while at the same time selling call options on that asset. When you sell call options against an asset you already own you are giving someone else the right to buy your asset if the price of your asset comes to a rest above the strike price agreed to in the call option contract. The seller of the call option then claims the premiums from the purchase of the call options in the hopes that the contract will expire below the strike price. In such an event the seller of the call option keeps the premium paid by the buyer and keeps the assets they already owned. However, if the price of the asset rises above the strike price, then the seller of the call options can be out of money or left with minimal profits. The buyer of the call option will exercise their right to buy the stock from you at the lower predetermined price. In this case the seller of the call option does not profit from the asset’s rise in value, and the seller’s maximum profit is limited to the premium received on sold call options.
Some investors are able to use options trading as a way to manage their number of taxable events within any given year. They are able to do this by using options to change up their portfolio allocations without actually having to buy or sell their assets. Let’s say that an investor did well on a given stock in the past year and is liable for a large unrealized capital gains. This investor could use options as a way to reduce their exposure to the asset in question without having to get rid of it by selling. Other investors like to speculate and play the game that is the stock market. Options trading allows these investors to be significantly involved in an asset/asset class with minimal risk, the risk being the premium to purchase the call options in the first place. This give them the opportunity to understand how an asset’s value is fluctuating and could earn the investor a great profit or it could end in a measly loss.
Just like most things, knowledge of the stock market and the terms and strategies surrounding it do not come preprogrammed in our minds. It takes conscious effort and practice to actually learn the ins and outs of the market. Dedication and commitment are needed in order to make a profit through the stock market. Just as easily as people seem to make money through the stock market it is even easier to lose money through the stock market. As always do your own due diligence before making any financial decisions.
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