Key Takeaways
Review your portfolio and financial goals.
Determine your outlook for the market or a particular security.
Assess whether there’s a place for options in your investment strategy.
Are you thinking about adding options to your investing arsenal? If so, it’s important to educate yourself about what they are and how they work before you jump in. Options can be versatile and flexible, with opportunities designed for any type of market movement—up, down, or sideways. However, they’re a bit less straightforward than traditional investments, and they come with their own lingo, which can take some getting used to. And, admittedly, options involve significant risks and aren’t suitable for everyone.
Check out this high-level overview to help you decide if using options is right for you.
The Building Blocks
Options are contracts that give the owner (holder) the right to buy or sell an underlying asset, like a stock, at a certain price (the strike or exercise price) on or before a certain day (the expiration date). A standard contract is 100 shares and the price to purchase it is called the premium.
There are two types of options: calls and puts. And each transaction involves a buyer and seller who have different outlooks on the market and different rights and obligations.
A Closer Look at Calls
Let’s look at why someone might consider buying or selling a call option.
| Buyer of Call Option | Seller of Call Option | |
|---|---|---|
| Rights/Obligations | Has the right (but not obligation) to buy a stock (or other security) at an agreed upon price before a certain date | Must sell the stock at the agreed upon price if the contract is exercised |
| Market Outlook | Rising (Bullish) | Falling (Bearish) |
| Potential Benefits | Can purchase shares of a stock below the market price | Earn a premium for the contract and won’t have to sell the stock if contract isn’t exercised |
| Potential Risks | Lose the money you paid for the contract because you don’t exercise it | Have to sell the stock at a price below market value; risk may be unlimited if you don’t already own the stock because you’ll have to first buy it at market value, which could be significantly higher than the strike price, in order to fulfill your obligation |
So how does a call option work? Think of it as an extension of a buy and hold investment strategy except you need to select a strike price and expiration date. For example, let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy 1 XYZ Call with a strike price of $25 expiring in January 2019. The option premium for the contract is $5. Your maximum loss is the amount you pay for the contract, $500 ($5 option premium x 100 shares) and your maximum gain is unlimited since there is no cap on how much the stock price could increase, not accounting for transaction costs. The breakeven point is $30 ($25 strike price + $5 option premium paid), so you are hoping that XYZ’s stock price rises above $30 before or on the expiration date.
Puts in Practice
Now let’s look at why someone might consider buying or selling a put option.
| Buyer of Put Option | Seller of Put Option | |
|---|---|---|
| Rights/Obligations | Has the right (but not obligation) to sell a stock (or other security) at an agreed upon price before a certain date | Must buy the stock at the agreed upon price if the contract is exercised |
| Market Outlook | Falling (Bearish) | Rising (Bullish) |
| Potential Benefits | Can sell shares of a stock above the market price | Earn a premium for the contract and won’t have to buy the stock if contract isn’t exercised |
| Potential Risks | Lose the money you paid for the contract because you don’t exercise it | Have to buy the stock at a price above market value |
So how does a put option work? Let’s say ABC stock is trading around $20, but you think the company’s sales are going to decline and the stock will go to $10. You buy 1 XYZ put with a strike price of $20 expiring in January 2019. The option premium is $2. Your maximum loss is $200 ($2 option premium x 100 shares) and your maximum gain is $1800 ($20 strike price – $2 option premium x 100 shares) if the stock goes to $0, not accounting for transaction costs. The breakeven point is $18 ($20 strike price – $2 option premium), so you are hoping that the price of XYZ stock falls below $18 before or on the expiration date.
The Key: Education
The basic call and put options described above are just the beginning. There are many different ways you can use options. Some are more complex than others. Understanding how options work and the potential benefits and risks of exercising contracts and transferring rights in a security (assignment) are essential for deciding what role calls and puts might play in your investment strategy. Depending on your risk tolerance and goals, options could be a way to potentially enhance your portfolio.
