Investing 101: Options Basics
You’ve heard the term before, but maybe you’re not familiar with the concept beyond ‘those high-risk bets that traders lose all their money on.’ Options. The reality is more complicated, but there are simple, smart ways to use options for any investor.
Let’s talk about what options are: an option is an agreement to buy or sell a specific stock within a given time frame, via contract. Depending on what side of the trade you are on, that will give you either a right or an obligation for that set period of time. Buying either a Call or a PUT (we will talk about this shortly) will provide you the RIGHT to either buy or sell 100 shares of a given stock at a set price while writing or selling either type of contract will give you the obligation to fulfill the contract terms if whoever holds it chooses to.
While being on the selling side might sound intimidating, there are distinct benefits to using them within a well-defined strategy. One of those benefits is that you are the one receiving the premium, or fee that the person paid to get the right to sell or buy. We will get into specific options strategies in the future, but just remember that being on either side of the trade has it’s uses and it’s important to understand the mechanics of what they do and why to make sure you're using them effectively.
Let's address the buy side of options transactions first, since that’s the easier to understand. When you’ve purchased, and now hold an options contract, you get to decide whether and when you buy or sell that stock. For our example we’ll be talking about an imaginary stock, ABC.
Today ABC is trading at $10.00 per share. You think that ABC will be going up to $15.00 per share within the next six months. Based on that prediction you decide to buy a call option on it. A call allows you to buy a stock at a pre-determined price. In this case you’re going to go out and pay someone to write a contract with you that they will sell you ABC at $12.00 per share any time within the next 6 months. That $12 price that we’ve now locked-in with the contract is known as the strike price. Look out for that term and you’ll hear it a lot in options discussions. For this privilege you’re going to pay them $1.00 per share for a round lot of 100 shares. You pay the other party $100 right now: that’s the premium of the options contract.
What this means is that you’re going to make money if and only if ABC goes above $13.00 per share in the next nine months. You’re already $100 in the hole from paying the premium, and you’re going to pay $12.00 per share for 100 shares if you exercise (or use) the contract, so you need it to trade at $13.01 or better per share to make any money on the deal.
The other party, the contract’s writer is going to stand to gain if the stock doesn’t trade above the strike price. They’re basically betting against you in this scenario. If, for example, ABC only ever goes to $11.00 per share, you’ll never use the contract (why buy it at $12 when you can get it at $11 on the open market?), and they’ll still have collected $100 from you at the outset: that’s a win!
This is the simplest, most straight-forward way to use options. You’re either betting that the price will go up and you’ll get your stocks for cheaper than market value (the buyer of the call contract) or that it will go down and you’ll get to keep the premium (the seller of the call contract).
So what’s a contract to guarantee a price to buy – what about if you want to guarantee a price at which to sell?
That’s called a put. The buyer of a put contract gets the right to sell the security they hold at a specific price, and the seller of a put contract agrees to buy the stock at that price, again collecting a premium as the price for that privilege.
Puts are useful to ensure that you don’t have to sell at the bottom of the market. Say you have 100 units of ABC, the stock we described above, and it’s currently trading at $10.00 per share. You’re worried about some factors affecting the stock, though, and think it could drop to $5.00 per share within the next six months. So what do you do?
You buy a put contract with an expiration date six months out and a strike price of $8.00. No matter how poorly the stock performs in that time period, you can always sell it for at least $8.00 a share. The contract might cost you $100 ($1.00 per share included in the contract), so you’re out a bit of money to start. This means that you’re really only doing better than break-even if the stock falls below $7.00 per share. You should still sell between $7 and $8, but you won’t even be recouping the cost of the premium with your savings on your position.
Just as with calls, puts have a few specific uses. The most common is to create a kind of ‘insurance’ on your largest positions. If you own, say, $1,000,000 worth of stock ABC you might be feeling a little nervous about the risks of that kind of concentration – but you also may not be interested in selling it if you don’t have to. You could buy a put on some or all of your ABC with a strike price down at something like $940 million. For the duration of that option, you will definitely not lose more than 6%. That’s the kind of insurance many people find useful.
Now you know the basic concepts of options trading, but it’s time to learn more about what options can do. There are a hundred different ways to use options, from speculation on a security's price movement to more complex multi-contract orders called spreads. We’ll discuss only the two most basic today uses of options here.
Creating or Eliminating a Position in your Portfolio
This is one of the most basic ways to use an option, but there’s a lot of nuance here. Using options with different expiration dates and strike prices is a great way to slowly build up a position, or reduce one, that you believe will be highly volatile over a given period.
If you believe in a company’s long-term strength, but don’t want to sink in all of your money right away, you might consider buying a series of calls, with one a month out, one for two months out, one for three months out, etc. This will allow you to add to your position at a guaranteed price over time, with a minimal initial outlay. If the price decreases, great! You can buy your allotment at the lower market price. Putting a cap on how much you’ll be paying to slowly build a portfolio position could be useful if you’re not that sure of the position; if you don’t have the cash on hand right now; or if you want a number of separate tax lots to control your capital gains better in the future.
The same goes for using options to eliminate your position. Buying puts in a series like that gives you a way to step down your ownership of a concentrated position at specific times and strike prices, freeing up cash to rebalance your portfolio or use for your living expenses.
You could also be considering writing options contracts to both generate income and allow for a reduction or addition to your portfolio. Is there a stock that you’d consider picking up at a given price but you’re really still on the fence about it? Sell a put on that security and you win either way: if it’s exercised you’ve collected a premium and added the stock to your portfolio at a price you’re comfortable with; if it expires you’ve collected your premium and can decide whether you want to pick up the stock at market price anyway. The same goes for writing calls. You potentially can move a stock out of your portfolio at a price you like, and either way you’ll get the premium.
It should go without saying that these methods are for long-term investors. You won’t be playing volatile stocks for a few cents a share trying to make a quick buck, you’ll be making measured additions and removals from your portfolio ahead of time and profiting in the long run.
Hedge Your Portfolio
You can hedge – or protect – your account in a lot of ways, but options are among the most flexible and inexpensive. This is really just putting put options to their most essential use.
If you have a concentrated position in your portfolio it can be nerve-racking to watch your account value bounce up and down by a few percent in a day. Even if you're sitting on huge gains over a long period – perhaps especially in that case – it's important to guard against a sudden drop.
Puts represent one of the most flexible and inexpensive ways to protect your portfolio. By using options with expiration dates way in the future (like LEAPs: Long-term Equity AnticiPation Securities, or options with expirations a year or three out) you can protect your largest positions with a relatively small outlay. Let’s use an example to put it in perspective.
In our example you’ve got a total portfolio of $250,000, of which $150,000 is imaginary stock LMN, 10,000 shares at $15.00 apiece, which you bought at a third that price a few years ago. The stock’s sudden rise has you concerned, because you can easily see it dropping to $10, a loss of $50,000 – a full 20% of your portfolio. How do you manage that risk?
If we’re trying to hold the whole position, puts are a great option. We’re going to ensure that we get a satisfactory price if we need to sell. Looking at the options market there’s a put dated 8 months out for $12.75, going for $0.35 per share. Since options are always sold in 100-share lots, that’s $35 for every 100 shares you want to cover. You’ve got 10,000 shares, so that’s $3,500 if you want to cover your whole position for the next 8 months. At 2.33% or so that’s not a terrible price to pay for ‘insuring’ your portfolio and providing some peace of mind.
For many of our clients, though, there are positions they don’t want to do away with wholly in the case that it starts dropping. Whether it’s a tax concern, sentiment, or a belief in the long-term value of the stock, you might choose to cover only a portion of it with this kind of strategy. To return to our LMN example, maybe you know you want to hold 5,000 shares for the long haul. You decide to cover the other portion of your position in bits and pieces: you buy a put for 1,000 shares at $13.00, another 1,000 shares at $12.25, and the last 3,000 shares at $11.00. Because those lower prices are considered less likely to occur, they’ll have lower prices to pick up those options, so maybe your total bill comes out to $1,050 to cover those 5,000 shares, or a cost of 1.4% to cover a value of $75,000 in the worst-case scenario.
Different portfolios will call for different strategies. If you love the work of statistics and prediction then exploring options can be a mentally and financially rewarding hobby. If you have questions about these strategies, or want help putting them into practice in your portfolio, reach out to us here.