What is an option?
An option is a contract between two investors wherein one pays money to the other in exchange for the right to buy or sell something at a given price before a set date. A call option grants the buyer the right to buy something. A put option grants the buyer the right to sell something. The money paid for the option is called the premium. The price specified in the option is called the strike price. The date through which the option exists is called the expiration date.
Options are often used to increase income, protect and speculate.
Income
A common income enhancing technique is selling “covered calls”. For premium – money received – you can sell a call option on a stock held in your portfolio. If the stock price remains under the strike price until expiration, the premium you received is a pure gain for which you gave up nothing. Moreover, after the option expires, you could sell a new covered call on the very same stock with a new strike price and expiration date. This can go on and on.
Offsetting this extra income is your reduced potential gain. If the stock underlying the call goes above the strike price, the owner of the call will exercise the right to take the stock from you at the option strike price. Yet, if the stock goes down, as owner you experience all the loss.
Protection
There are times you will be nervous about near-term market prospects. You can sell stock and hope for good timing; a rare event (Chapter 42). You can weather the storm. Alternatively, you can buy put options for one or more of the stocks in your portfolio. If the price of a stock falls below the put strike price you will be able to exercise the put option and receive that strike price for your shares. If the stock price rises, you still own the stock and profit accordingly. Of course the money you spend on put options will be money out the door in either situation.
Speculation
Options can be used to profit from stock movements far more dramatically than you could through the stocks themselves.
For example, a 100-share lot of a $100 stock costs $10,000. If the stock price moves up $10, your profit would be $1,000, or 10%. If a call option on the same stock costs $10, you could buy options on 1,000 shares for the same $10,000 investment. Given the same $10 increase in the share price and a one-for-one increase in the option price, your options value will rise by $10,000, a 100% rate of return. Conversely, if the stock did not rise above the call price before the expiration date, the options would become worthless – a loss of 100%.
Why you should avoid options
Nothing is secured
Options are derivative securities. They are contracts that expire relatively quickly. Often there are no resulting transactions other than an option’s creation and expiration.
Negative sum game
Bond market participants can all do well as interest is paid to all holders. Similarly, all stock market participants can do well in the long run as economic growth leads to earnings growth, share price gains and dividends. But for every option there is a winner and loser. At best, trading options is a zero-sum game. Because there are transaction costs, it is actually a negative sum game.
Total loss a frequent occurrence
Some fans of options trading suggest they are a mechanism to buy into a company cheaply. Why pay $100 for a stock when you can pay $5 for a call option? This is a false comparison. What matters with any investment is the upside potential versus downside risk. If you buy a stock and it goes down 5%, you still have 95% of your investment. If you buy a call option on a stock at its current price and the stock drops 5%, you will have lost every penny you spent. Further, if you sell options and the market goes in the opposite direction you were hoping, your potential losses are unlimited.
The dramatic impact of option behavior is demonstrated in the following charts. Both assume a current stock price of $100 and a $5 cost for a call option on the same stock with a strike price of $100. Figure 32-1 shows the dollar gain and loss per unit (share/option) given ending prices for the stock between $90 and $110. The stock investment has zero profit or loss if nothing changes; it gains and loses value dollar for dollar. The option generates a loss if nothing happens, if the stock goes down, or if the stock rises by less than the cost of the option. Once the stock is above $105, the option is profitable.
Figure 32-2 highlights the percentage returns as of the expiration of the option. In the case of the stock, a $1 decline renders a 1% loss; a $10 decline, a 10% loss. Rises by the same amounts generate profits of equivalent percentages. In the case of an option, if the stock falls at all, you lose 100% of your investment. If the stock does not move, you also lose everything. If the stock rises $1, the option “only” renders an 80% loss. If it goes up $2, the damage is 60% of your proceeds. If the stock gains $5, the cost of the option is recouped and you break even. Gains greater than $5 will finally create profit.
Options entail some possibility for gain; they would not exist otherwise. But instead of mild underperformance in the case of a wrong guess, bad timing or mere stability, options risk total loss.
Perpetual deterioration
Options have an expiration date. When you buy one, part – sometimes all – of the premium you pay is an extra amount that takes into account how much time remains for the conditions of the option to render profits. If a stock sells for $100, a call option that allows you to buy that stock at $95 will cost about $5 on the day it expires. But a $95 call option expiring in two months will cost much more than $5 because a lot can happen during that period. If you pay $12 for the option, $5 is ‘intrinsic value’ representing the difference between the stock price and the strike price; $7 is the time value. This time value will decline to nothing as of the expiration date. All options will lose all of their time value upon expiration.
What you should do instead
Options present high risk, negative aggregate returns and much time commitment. Good investing emphasizes the opposite.
If your interest in buying call options is based on the hope for magnified returns from a stock you like, buy the stock instead. You could be right about the long-term prospects of a company, buy options, and still lose your entire investment upon expiration. Owning the stock you can be patient and profit.
If your interest in buying put options is based on fear of imminent loss of portfolio value, beware the folly of trying to time markets. If the bad events you expect do not transpire before expiration, you face total loss on the options held and the hard choice of spending even more money for more puts. Instead, you could sell the stock you now hold in disfavor and either buy something else or hold cash for a spell. If your interest in selling options is to generate extra income, skip it. The income from options represents the maximum you can gain. If the stock moves in the wrong direction, your potential losses – or lost opportunities for gain – are huge; many times the income you receive. Consider stocks and stock funds with higher than average dividends and bonds.