Options
Introduction to Options
Options are a very versatile trading instrument because they have an advantage over other types of investments: Investors are not limited to making money only when the market goes up.
Just by knowing some fundamentals about how options work, you can make a profit even if the markets are down. Option traders around the world are making profits every day on the rise and fall of equity markets.
Educated investors use options to either speculate, to be aggressive with their positions, or to be conservative and hedge, or protect, their existing positions. Options can be used to help investors be successful in a variety of investment strategies.
Examples to Consider
A few examples of how options can be used are as follows:
- Options can provide the investor with leverage to benefit from the stock’s price movement without ever owning the underlying stock.
- Options can be used in a way that eventually allows the stock to be bought at a price lower than the current market price.
- Investors can protect their stocks even when the market is in a downturn by using options.
- By executing certain strategies, you can potentially make a monthly income on stock that you currently own.
You have probably been told that options are risky. This is true when they are used primarily for speculation purposes. Investors use the leverage available through options to speculate and to generate large profits on small price movements. The problem is that if the investor does not gauge the share price movement correctly, small price movements could also lead to large losses.
Despite the publicity surrounding the risk of options, the fact is, though, that options can also be used for conservative strategies, not just aggressive ones. For example, some of the earliest applications of options were where investors used them to reduce risk, not increase it.
Historical Information
Options have been blamed for investor losses in history. For example, during the Dutch tulip mania in the 1600’s, Dutch growers and distributors traded tulip bulb options to lock in prices. This allowed the growers and distributors to protect their profits in a time when the price of tulip bulbs was increasing. The demand for all types of bulbs was increasing at the time because tulips had become popular with royalty and had, therefore, become a status symbol. As prices increased, more and more people entered the bulb options market for speculative purposes – i.e. they were betting on the further price increases.
And prices did increase, in the beginning. This initial success led to even higher levels of speculation, and the bulb prices continued to skyrocket. Eventually prices hit a peak, and they began to drop. Speculators who had been betting on increasing prices began to suffer significant losses. Many lost their life savings and homes. Banks even began to fail because investors had used borrowed funds to invest in options. Although greed and reckless speculation were the cause of the financial collapse, options were blamed.
As with any financial investment, an investor needs to understand the how options work to fully appreciate the leverage and therefore the risk they are exposed to.
Let’s move on to another historical example where the mechanisms of options were initially misunderstood.
In the 1920’s, the options market in the U.S. was unregulated. Abuses by underground option pools were common. Congress held hearings and eventually decided to establish an oversight committee, which nowadays is called the Securities and Exchange Commission (SEC). The oversight committee’s initial proposal was to make it illegal to trade options.
During the Congressional hearings, the Put and Call Dealers' Association was allowed to speak to explain why options trading should remain legal. The Association explained the difference between options that were openly dealt with put-call dealers and options that were traded within the underground pools for no fees. They explained that there were good and bad options and that the public awareness of the bad options was leading Congress to conclude that options trading should be made illegal. The proposed bill originally stated: "not knowing the difference between good and bad options, for the matter of convenience, we strike them all out."
Members of the committee were also concerned about the number of options that were never exercised and expired worthless. At the time, one of the committee members asked, "If only 12.5% are exercised, then the other 87.5% of the people who bought options have thrown money away?" The reply from the Put and Call Dealers’ Association was, "No sir. If you insured your house against fire and it didn't burn down you would not say that you had thrown away your insurance premium."
The Dealers’ Association’s argument was so convincing that the oversight committee revised its initial recommendation and decided that options were a valuable investment tool when used properly. Options trading lived on in America. In fact, the SEC still regulates the options industry today.
What is an Option?
An option is based on, or derived from, an underlying asset. In other words, an option’s value is derived from something else and is, therefore, called a derivative. Two types of options are available to investors – call options and put options.
With a call option, the investor has the right, but not the obligation, to buy the underlying asset that the option is based on at a predetermined price. A put option is the opposite situation. The investor has the right, not the obligation, to sell the underlying asset at a predetermined price.
In either case, if the option holder does not exercise their right before the predetermined time associated with the option, the opportunities to exercise it expires.
Four types of players participate in the options market:
- Buyers of calls
- Sellers of calls
- Buyers of puts
- Sellers of puts
Another name for buyers is holders. Likewise, an alternative name for sellers is writers.
Seller (Writer)
A seller, unlike a buyer, is obligated to buy or sell the underlying asset if the option is exercised.
In the case of a call option, the option owner has the right to buy the underlying asset. Because the buyer is obligated to sell, the owner of the option is said to have the right to “call” the stock from the seller. The opposite is true for a put option. In this case, the buyer is obligated to buy the underlying asset of the option. The option owner is said to have the right to “put” the stock with the seller.
[ Back to top ]