Knowing Your Options

Even with all of the books and seminars that are available today, options remain one of the most misunderstood of all investment strategies in the financial world. Option trading can provide some of the best ways to leverage your money to make a profit without having to increase the risk to your portfolio. With that said, you would think everyone in the world would be an option trader. But the fact is that a large majority of investors have never even placed a simple option trade. What is one of the reasons for this? … FEAR.

Not only are options misunderstood, they are also the most feared. Human nature tells us to fear the unknown, and for good reason. Imagine if we were to roam about the world without concern for our own safety. This would be foolish. Any traveler knows that you just don’t enter into a foreign land without knowing where the danger areas are. Roaming about in such a manner would eventually get you into a dangerous situation. Therefore, it is a survival instinct to be, at the very least, cautious of our surroundings.

One of the other reasons many people shy away from options is the misconception that they are extremely risky. As a result, those who have incorrectly traded options are left with an experience that was more like speculation or gambling. However, other investors feel that options are safe and are a great way to hedge a portfolio against risk, similar to an insurance policy. This belief leads to a sense of security, making those who have traded them successfully feel that option strategies should be part of every investment portfolio. So how can the same asset cause people to have such opposite opinions? The reason is that options can be risky and speculative while at the same time be secure and prudent. This all depends on how you use them.

We see the same opinions in the credit markets. For those of you who have teenagers in the family, you know that a credit card can be a dangerous thing in the hands of a young adult who is unfamiliar with the dangers of going into debt. If you were to give the average college student a credit card in their own name, there is a good chance that student would run up the limit on that card within a 12-month period. This excessive spending could even wind up with that student having to file bankruptcy to get out of this financial mess. On the other hand, you might have someone who just uses a credit card to take care of emergencies in the event they are traveling and run into a problem along the way. This person may also be inclined to pay off the balance of the credit card each month to ensure that the debt doesn’t get out of hand.

Back in the 1970s, options were introduced as an instrument to mitigate risk. Traders would use option contracts to hedge existing positions in a way that some people would use insurance policies. Interestingly enough, you have already been exposed to the world of options if you’ve ever purchased automobile insurance. In the world of insurance, the buyer of the policy pays a premium to an insurance company to have the value of their car insured.  Should the owner or driver get into an accident, they are protected by this policy for the replacement value of the car.

Example: A car owner purchases a term policy by paying a premium to an insurance company. In return, the insurance company issues a policy that states a “face value”, which covers the underlying replacement value of the car. The term for this policy is 12-months, which means that the policy will lapse at the end of the 12-month period, at which time the insured will have to renew the policy after it expires.

The insurance policy I’ve just described is similar to what an investor would buy in the form of a Put Option, should they want to purchase insurance on a particular stock position.

Example: An investor purchases a specific “Put” and pays a premium to the seller, who is assuming the role of the insurance company. This put contract has an expiration date and a stated value that’s called a “Strike Price”. The strike price is similar to the face value on an insurance policy.

Keep in mind that these examples are used to explain very basic option concepts, which means that there is a lot more you’ll need to learn before you start trading options. But at least this will get you started with a basic understanding of how they work.

What is an Option?

There are two types of options: Puts, as I’ve just described, and Calls. A Call Option gives the owner the right to buy stock at a specific price over a given period of time. In other words, it gives you the right to “call” stock away from another person. This is also something you’ve been exposed to, especially if you've ever used a coupon to buy, let’s say… pizza.

Example: A local pizzeria offers you a coupon to buy an 18” Pizza for $5. On the bottom of the coupon you will most likely see an expiration date which basically locks in the $5 price of the pizza until the coupon expires, at which time the coupon is no longer valid.

With a Call Option, the seller of the contract allows you to lock in the price of a stock for a given period of time. In this case, the agreed upon price is called the “Strike Price” and, like the pizza coupon, the call has an expiration date attached. Let’s say you are able to lock in the price of a stock at $5 a share, and the price of that stock rallies up to $10 a share while you are holding on to this call option; you could then sell the call for a profit or, you could “exercise” your right to buy the stock at the stated Strike Price. The main difference between a call option and a pizza coupon is that you’ll have to pay a premium for the call, whereas the pizza coupon is usually given to you by the pizzeria for free, for a discounted purchase price.

As I mentioned earlier, there is a lot to learn about options but at least this will give you a basic understanding about how they work. If you would like to learn more, feel free to visit The Market Guys video library, where you will find short educational videos called “Market Shots”. The length of each video ranges between 6 to 8 minutes, making it easy for you to fit these lessons into your busy schedule. I would also recommend that you visit https://www.theocc.com/components/docs/riskstoc.pdf before you start trading options and download a free copy of Risks and Characteristics of Standardized Options.

By AJ Monte CMT
Chief Market Strategist
The Market Guys, Inc.