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.
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