Just mention options and even some of the most seasoned investors will have the same knee-jerk reaction: “They’re too complicated… too risky… too expensive.”
But this is just that — a knee-jerk reaction. In reality, if you know what you’re doing, options trades can be quite straightforward and open up a world of relatively safe alternatives to making money with stocks. In fact, options can even be a great deal more inexpensive than stocks… and deliver greater profits in a shorter time frame!
Options really shine when the markets are volatile. You can use them to leverage the movements of stocks or other tradable assets as they swing both up and down. And right now — with uncertainty rife in economies and governments all over the globe — is a perfect time to play the options game as the markets experience wild mood swings.
But what exactly are options… and how can you use them to your investing advantage? In this primer, we’re going to give you the basic rundown on what options investments are and how to place a very basic trade.
So What the Heck Are Options Anyway?
Here’s the best way to think of options: They’re bets on the future. Essentially, options are contracts that grant the right — but not the obligation — to buy or sell a stock on or by a certain date at a set strike price. They’re a type of financial instrument known as a derivative because options contracts derive their values from underlying assets. For this primer, we’re going to assume that the underlying assets are stocks.
And simply put, there are two basic forms of these contracts: call options and put options
We call the right to buy a stock a call option. These are bullish bets — you believe that the price of the underlying asset will rise by a specified time. With these options, money is made when the price of the underlying asset increases in value.
We call the right to sell a stock a put option, and it’s exactly the opposite of a call. These are bearish bets that the price of an asset will drop in value.
You purchase options via a contract. Each contract — be it a call or a put option — controls 100 shares.
Let’s explain each of these options contracts in more detail.
When You Think the Asset Is Going Up in Value — Use a Call Option
Believe it or not, popular e-commerce site Groupon gives us a great analogy for explaining how call options work. You open up your email and find a deal that gets you dinner for two at a super-fancy fixed-price restaurant for $100. This is such a deal — usually, you’d be looking at a $200 bill.
You buy the coupon for $100, and you must use it before it expires in 60 days. However, within two weeks of purchasing the coupon, the restaurant decides to raise its menu prices, and a dinner for two on the fixed-price menu now costs $225. You’ve realized a bit of profit here, since the restaurant is obliged to honor your coupon, for which you spent only $100.
When you buy a call option for a stock, you’re essentially doing the same thing. You’re buying the right to purchase shares of a company by a certain time in the future for a specific price.
An Example of a Call Option
Say you think that Apple, which is trading around $140 per share, is a great but undervalued stock and that it’s going to rise within a month, by June 1. You buy a call contract that states you have the right to buy 100 shares of Apple on or before June 1 (the contract’s expiration date) for $150 (the strike price).
Your instincts about the company are right, and by June 1, positive news has shares of Apple up to $200. At this point, you can exercise your option and receive 100 shares of the company for a steep discount; you would pay only $150 per share. Then you can sell them at the full price for an instant profit of $50 per share (minus the cost of the option and broker fees).
What if you were wrong? Well, if Apple shares actually drop to $120 during the month, you just let your contract expire and lose only the amount you spent to buy the call contract.
One of the advantages of an options contract is that the price to hold the options is much cheaper than the cost of directly owning the 100 shares of Apple in the example above.
When You Think an Asset Is Going Down in Value — Use a Put Option
Put options work the opposite way of call options. Say you think Tesla actually sucks. You think that its stock is going to fall from $300 per share by June 1. You buy a put option that states you have the right to sell 100 shares of Tesla at the $310 strike price by that date.
Your negative instincts were right, and Tesla’s stock plummets to $250 within the month. However, because of your put contract, you can now buy these $250 shares and sell them each for $310, a profit of $60 per share (minus the cost of the option and broker fees).
Of course these are very simplified examples. There are many other variations on the basic themes we’ve discussed in this primer. But hopefully you now have a good idea of how you can use options to make money whether a stock goes up or down.
(Important note: Before you start trading options, make sure that your broker has cleared you for “take-off.” You’ll need to fill out a special for to receive clearance. Here’s more info about the process.)