Options are an asset class in their own right, like stocks, bonds and ETFs. They grant the right to buy or sell an asset at a later date for a predetermined price, no matter what happens to that asset’s value in the meantime.
When you buy an option, you are essentially betting that the price of the underlying stock will rise above the price of the option, allowing you to profit from the difference.
The contract is not an obligation and comes complete with an expiry date. As that expiry date approaches, options typically lose their value as there is less time left to benefit from divergence between the price set by the option, and the current market price.
Because of this, trading in options can be risky. Even if the underlying stock stays at its current value, the option will lose value as the expiry date approaches and you can eventually lose 100% of that value.
If you feel confident though, there are gains to be made – especially as part of a diversified portfolio of which options form only one speculative part.
Benefits of trading options
Why risk trading options when you could invest directly in the underlying stocks with less risk of losing 100% of your investment?
One reason is because the returns you receive can be larger and faster than waiting for the stock to rise in value.
Another is because you can invest in put options as well as call options – allowing you to speculate on both sides of the buyer/seller relationship.
Call vs. put
‘Call options’ give you the right to buy shares in the underlying stock at the pre-agreed price at any point up until the expiry date.
For most beginners, this is the more ‘familiar’ way to trade in options, as you are basically just capping the price of the potential future purchase.
‘Put options’ reverse this relationship, giving you the right to sell shares in the underlying stock to the option writer, typically in multiples of 100 shares.
This means there are four basic ways to trade options: as an option writer who sells either call or put options, and as an investor who buys those two different types of contracts.
Assuming you are the buyer, a call option represents a gamble that the value of the underlying stock will rise, whereas with a put option you profit when the underlying stock falls.
Theoretical profit from a call option
As the buyer of a call option, your potential profits are pegged to the change in value of the underlying stock, less the premium you paid for the option.
Because options trade in blocks of 100 shares, that net difference is then multiplied by 100 to give you the total profit across all 100 shares in the option.
Likewise if you buy more than one option, your total profit will be the gain per option, multiplied by the total number of options you bought.
Together these compound gains can add up to a significant rise in value for a relatively small move in the underlying stock.
Covered calls
The theoretical loss for the writer of a call option depends on whether the call is ‘naked’ or ‘covered’.
In a naked call option, the writer does not hold shares in the underlying stock, which means if the value goes up and the buyer exercises the option, the writer faces a loss equivalent to the difference in value between the stock and the price set by the option, minus the initial premium paid.
Covered calls are different. In a covered call, the writer already holds sufficient shares in the underlying stock to sell to the buyer if they exercise the option.
Because of this, the option writer is insulated against those largest potential losses; however, if the buyer were to exercise the option, the writer would still lose the equivalent number of shares from their portfolio, along with the associated value.
Are options ever exercised?
Options are not often exercised in real-world trading. For most investors they are not an intention to buy the shares, but are merely a gamble on their future value.
In this sense, options are similar to trading in commodities futures, when you are unlikely to want to take delivery of physical gold or oil, and just want to benefit from any change in value before your contract expires.
Most options are sold back before expiry as investors look to close out their position and recover the maximum value possible – even if this represents a net loss.
In some circumstances the investor may not choose to do this and the option could simply expire with no shares actually changing hands at all.
But if you want to take a put position rather than a call position, you should be aware of the possibility that the buyer may exercise that option, forcing you to hand over the agreed number of shares.
If you have not covered that call in advance, you could be left paying a higher purchase price for shares you immediately have to sell on at a loss – so it’s important to keep this in mind when deciding your position during options investment.
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
