Basics of Options (Derivatives) in Investment Portfolios

When you think of investments, things like stocks and mutual funds come to mind. However, there are the more advanced type of investments available for investors, they are called Options. When you play with stock options, you can be conservative or speculative or even sophisticated. However, stock options can be extremely risky and can cost you big time.

That's the reason why you will commonly see disclaimers like these when investing in stock options: "Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital."

In order to become a successful stock options investor, you need to master the basics. In this article, we go over some of the characteristics of Stock Options.

What are Options?

An Option is a contractual right given to an individual allowing him to buy or sell an underlying asset (common stock, derivatives, etc) at a specific price on or before a certain date. Options are similar to stocks and bonds in that they are all securities that have strict defined terms and characteristics.

Take a real life example. Imagine you want to purchase this piece of jewellery for $50,000 but you do not have the cash upfront. However, 6 months later, you will have enough cash to afford the jewellery. So you make a deal with the owner, giving you the option of purchasing this piece of jewellery for $50,000 in exactly 6 months from now. However, to give you the right or this "Option", the owner charges you $2500. From here, you stand to either gain from the transaction or lose from it.

This piece of jewellery actually turns out to be one worn by a famous celebrity many years ago! Therefore, its fair market value skyrockets to $200,000. Since you have the contractual right or option to purchase this item for $50,000, you will make a profit of $200,000 - ($50,000 + $2500) = $147,500. Note that the $2500 is also included in this profit analysis, this is because that $2500 was paid to acquire the option or the right.
This piece of jewellery actually turns out to be fake and the owner cheated on you! The actual worth of the item is only $20,000! Since you realize this last minute, you let the expiration date go by and do NOT purchase the item for $50,000. However, you would still lose the $2500 you paid to acquire the option.

The above 2 transactions show 2 very important concepts:

When you buy an option, you have the right to do something, but NOT the obligation. Since the jewellery skyrocketed in value, you had the right to purchase it at $200,000. However, in scenario #2, since the owner cheated you, you have the right to let the expiration date go by, and do NOT have the obligation to buy the item.
If you let the expiration date go by, you will lose all the $2500 you paid to acquire the option. For this reason, options are called "Derivatives."

How do you summarize the definition of a derivative or an option? An option is a contractual right that deals with an underlying asset. In our example, the piece of jewellery is the underlying asset. The option "derives" its value from the piece of jewellery. This is where the word derivative comes from.

Types of Options (Calls and Puts)

The 2 types of Options are called Calls and Puts.

Call: A call gives the holder the right to acquire or buy an asset at a certain price within a specified period of time. Holders of Calls hope that their asset goes up in value substantially for them to make big profits.
Put: A put gives the holder the right to dispose of or sell an asset at a certain price within a specified period of time. Holders of Puts hope that value of the asset goes down in value substantially for them to make big profits.

There are 4 types of Options Participants:

Buyers of Calls
Sellers of Calls
Buyers of Puts
Sellers of Puts

Buyers of options are called Holders while sellers of options are known as Writers.

Compare & Contrast Between Buyers and Sellers

Call holders and Put holders (buyers) are NOT obligated to buy or sell. They merely have the rights to do so, they can either exercise their rights, or let the option expiry date pass by after which their options become worthless.
Call Writers and Put Writers (Sellers) are obligated to buy or sell.