Genre Note: This paper is intended to be accessible to those with no background in business or finance. It attempts to educate informally and simply so that readers can focus on content rather than verbage.
Options may be the most under-utilized financial instrument amongst layman investors. While some people rely on financial advisors to invest their money, many others do so on their own. Many of these personal investors are unaware of options and most who are see them as an incomprehensible tool for only the savviest of investors. This paper is my attempt to dispel that notion by clearly and simply outlining how options work and why they’re so valuable. Before we can dive in, we first need to cover the basics of how stocks are bought and sold. Next, we’ll look at what options are and how they work. Last, I’ll outline three ways that options can be paired with traditional stock ownership to maximize profit.
A share of stock represents a tiny piece of ownership in a company. These shares can be bought or sold by anyone with an internet connection through a stock exchange. Buying stock in a company you believe in is one of the simplest forms of investing. If that company becomes more valuable by releasing a new product or signing a big contract, each share of ownership also increases in value, giving investors a profit. Those investors may sell their shares at a higher price to close their position and take the cash. Unfortunately, companies don’t always go up in value. When this happens, people holding shares lose money because if they sold their shares to close their position, they’d receive less money than they paid originally. However, there is a way to make money on companies that are expected to go down, called short selling. Short selling is best explained through analogy. Imagine you have a friend leaving on a month long trip. Before they go, they let you borrow their bike. Soon after, your neighbor sees the bike and offers to buy it from you for $150. Two weeks later, your neighbor, disappointed by the performance of the bike, asks if you’d buy it back for $100. You gladly accept, and return the bike to your friend upon their arrival, pocketing the $50 difference. In summary, you borrow a share of stock and sell it, hoping the price will fall. If it does, you can buy it back at a cheaper price to close your position and pocket the difference. Understanding the mechanics of short selling is a must to utilize options.
An option gives you the right, but not the obligation, to buy or sell stock at a certain price. That price is known as the strike or strike price. The stock that an option refers to is called the “underlying” or “underlying stock”. The flexibility of an option lasts until its expiration date, and costs a fee called the premium. There are two types of options, calls and puts. Calls give the holder the right to buy stock and puts give the right to sell. Forexample, a “June 17 AAPL 140 Call” option would give the holder the right to buy Apple stock for $140 before June 2017, regardless of the market price of Apple stock at that time. This option becomes valuable if the stock price goes over $140, because it’d allow you to buy at a discount, however if the price never surpasses $140 prior to the expiration date, the option will expire worthless. Think of a call as a coupon that can be bought or sold, and lets the holder buy stock at a certain price. Just like stocks, you can buy or sell both calls and puts. When you buy a call or put, you pay the option premium in exchange for flexibility. Selling calls or puts gives someone else the right to buy or sell at the strike in exchange for the premium. Selling options works similarly to short selling stock. In both cases, you are required to buy back the borrowed option or fulfill the wishes of the option buyer by buying or selling stock. Options can be combined to build unique strategies that do almost whatever you want. You can design a strategy that makes money if a stock price doesn’t change at all, or only profits if the underlying stock moves drastically. You can build setups with fixed risk and unlimited upside or vice versa. Options give you drastically more control over your investments by allowing you to tailor strategies to your risk tolerance, bank account, or outlook. For the remainder of the paper, I’ll outline three basic options strategies to use in conjunction with stock ownership.
The first and simplest strategy uses options to “hedge”. A hedge can be thought of as an insurance policy. If you’re holding 100 shares of Google stock right before they make a big announcement, but don’t know if the news will be good or bad, you could use options to hedge your position and limit your risk if the stock takes a downturn. Let’s take the example further: Assume the stock is at $500 per share, meaning that you’ve invested $50,000 in Google. If the company announces that they’ve been hacked and the stock price drops to $450, you would lose $5,000 almost instantly. Here’s where options come in. If instead, prior to the big announcement, you purchased a $490 put (giving you the right to sell your Google stock for $490 before expiration, even if it’s only worth $450), it would cost you less than $500, but save you $4,000. It’s important to note that hedging isn’t perfect, if the announcement was positive, that $500 you spent on the put option would be wasted.
This next strategy, selling cash-secured puts, is a bit trickier, but much more exciting, because instead of just limiting risk, it can generate profit! First, you select a stock that you’d be interested in owning, but don’t buy it yet! We’re going to use this strategy to generate revenue until the stock price falls a bit so you can buy it for less. For this example, let’s assume we’re considering the $500 Google stock again. To open your position, you’d sell a put with a strike price less than the current stock price, for example $490. You’d immediately receive a credit, which is the cost that someone paid. In exchange, you’d give the buyer the right to sell you their Google stock at a price of $490, even if it’s worth less than that. As long as the stock price never falls below $490, you’d simply keep your initial credit and continue to sell a new put for more credit every month after the one before expires. Once the stock does fall below $490, the buyer will take advantage of the flexibility you gave them and sell you their stock for $490, allowing you to buy it $10 cheaper than you saw it initially, and putting a lot of money in your pocket in the meantime. The one big caveat for selling cash-secured puts is that you must have enough money in your account to purchase the stock at the strike price you establish.
This last strategy, selling covered calls, is the most popular options strategy, and for good reason. It’s basically the reverse of the cash-secured put strategy. First, you pick a stock that you’d like to own and buy it when you’re ready. Holding shares of the stock allows you to sell covered calls every month. Selling covered calls give you an immediate credit in exchange for giving someone else the flexibility to buy your stock from you at a certain price. Using the same Google example, you’d sell a call with a strike price around $510. For every month that the price of Google stays below $510, you’d get to keep your credit from the call you sold that month. As soon as the stockrises about the strike price, you get to sell it for more than you initially paid for it! This win-win situation is why this strategy is so prevalent, and perfectly exemplifies the power of options.
I hope that this brief introduction to the ominous world of options let you see that they aren’t just for Warren Buffet. In a few short pages, I could only scratch the surface, but the content above should act as an effective diving board to learn more if you’re interested! With a little bit of research and some middle school math, you too can harness the power of investing with options!