Anything that has to do with investments will be subjected to risk and return. Normally, the higher the risk the higher will be the return. Is there any investment that can provide you the opposite, where the potential risk is reduced while the return will actually increased? The answer is YES and it is through Options.
The beauty about options is that it offers limited downside (through premium) and unlimited upside potential (through profits). If you get too adventurous by speculating on ‘naked options’ or uncovered options then you are in deep trouble because your downside will be unlimited.
Another thing about options is that it enables you to play the market both ways and that is up or down. By buying a put option, you are hoping for the price of underlying securities to go down. However, if the price of the security goes up, your losses will only be limited to the premium. If you are short selling on the physical securities, your downside will be unlimited because you don’t know how much the price of the securities can go up to. Hence it will give you sleepless nights.
Not knowing how to make money both ways in the market is like knowing how to drive a car ahead but don’t know how to reverse.
The thought of investing in Options actually terrified most people because to them anything that sounds sophisticated must be very risky. What is a stock option? A stock option gives the right to the to the owner to buy or sell a listed stock at an agreed upon price and an agreed future date. Stock options are contracts that consist of 100 shares of a particular stock.
Or we can put it in layman’s term, an option is simply a contract entered between two parties. One party is the buyer of the contract and the other is the seller of the contract.
For the sake of illustration, say you own a piece of land, and you want to sell it for $50,000. You can either sell it through the real estate agent or you can enter into an agreement (option) to allow someone to purchase your land for $50,000 for the duration of a year. You sell the agreement (option) to the person for a premium of $5000. During the duration of one year, the price of the piece of land may fluctuate. Under the terms of the contract, the purchaser has the right to exercise his right to purchase the land if the market price went up to say $70,000. You, as the seller will have to sell at the predetermined price of $50,000 plus the premium of $5000, which totaled up to $55,000. The buyer of the agreement will make $15,000 ($70,000 - $50,000 - $ 5,000) from this deal.
But what happens if the price of the property declined to $40,000 during the one year period. The purchaser of the agreement will have two options whereby;
- To purchase the price of the land at $50,000
- Abandon the deal and lose the $5000 premium
Types of OptionsThere are two types of options, either puts or calls options.
A put gives the holder the right to sell a specific number of shares (normally in 100 shares lot) at a fixed price and date in the future. A purchaser of a Put option is hoping for the stock price to go down.
Options are normally quoted in the following format;
1 IBM Jun 145 Put – Premium 9
- 1 – number of contracts of 100 shares
- IBM – Underlying securities
- Jun – the expiry month
- 145 – the exercise or strike price
- Put – type of options
- 9 – denotes the premium paid by buyer to seller
Say an investor purchase the above option. What this means is it allows the investor the right to sell (put) 100 shares of IBM at $145 from now till June. For this privilege, the investor will have to fork out $900 ($9 x 100 shares) as a premium. The premium of $900 will be given to someone on the other side of the trade who already sold the contract.
A call gives the holder the holder the right to buy a specific number of shares at a fixed price and date in the future. A purchaser of Call option is hoping for the stock price to go up.
A normal Call option look like the following;
1 Microsoft Nov 300 Call – Premium 15
- 1 – number of contracts of 100 shares
- Microsoft – Underlying securities
- Nov – the expiry month
- 300 – the exercise or strike price
- Call – type of options
- 15 – denotes the premium paid by buyer to seller
This option allows the purchaser of the option the right to buy (Call) 100 shares of Microsoft at $300 from now till November. For this, the purchaser had to pay $1500 ($15 x 100 shares) as the premium.
For this case if the price of Microsoft shares goes up above $300 say to $350, the purchaser can then exercise his option by buying at $300 and sell it at $350. The net profit will be $50 x 100 shares = $5000 and then minus off the premium which is $1500. The net profit will be $3500 and so by investing $1500 the investor is able to realize a profit of $3500, which is more than 200%. If the price goes down below $300, the investor will not exercise the option and will lose his premium, which is $1500.
So this is what we call the limited downside ($1500), but unlimited upside (more than $3500) if Microsoft share price goes above $350.
P/s : Part 2 we will be looking at factors affecting option prices