Options were originally designed to act as insurance against share declines or rapid rises. For example, if an investor owned 1000 shares of XYZ stock and was worried that it might decline in price but didn’t want to sell the shares, she might buy 10 put options. Each put option allows the investor to sell 100 shares at the strike price. The put options would give the investor the right, but not the obligation, to sell the shares at a predetermined price. Like any insurance contract, the contract would expire after a certain period of time. If the stock dropped below the predetermined price (called the strike price) before the date the insurance contract expired, the investor would be able to sell her shares for the strike price. Like any good insurance, this limited the loss for the investor.
A similar insurance contract was created on the other side of a trade. This policy, called a call option, allows an investor to buy shares for a particular price before a particular date. To mirror the example given with the put option, a call option might be used by a short seller who wants protection in case the shares of a stock he has sold short rise rapidly. By owning call options on the stock he has short his loss is limited since he can always buy back the shares at the strike price. (For an explanation of short selling, see the post, Short Selling: https://smallivy.wordpress.com/2010/05/02/short-selling/).
The most common use of options is for speculation rather than insurance. For example, a speculator may decide that Google stock is about to go up, but doesn’t want to pay the $600 per share that Google is trading for that day. That investor instead could buy call options that would allow him to buy shares of Google at $600 anytime in the next three months. These options might cost $10 each. If the investor wanted to have the right to buy 1000 shares, it would cost him $10,000 :
($10 X 100shares/option X 10 options).
At $600 per share he would effectively control $600,000 worth of stock for the $10,000 speculation. If the stock then went to $650, his call options would be worth at least $50 each (because anyone who purchased them could buy the stock at $600 and immediately sell it for $650), so he would have made $40,000 on the deal. This would be a 400% profit on a stock move of less that 10%. This is what is known as leverage, the control of a large amount of money using a little amount of money, such that small movements in the stock result in large profits.
The issue with leverage, however, is that it cuts both ways. Because the speculator needs to be right not only in the direction of the stock movement, but the timing, using options for speculation is very risky. Every minute of every day, the value of the options decays until it becomes worthless on the expiration date. If Google never moves above the strike price while the options are still in force and the options are held until expiration, the investor will lose the whole $10,000, even if Google goes to $700 the next day. Most option contracts expire worthless, so the buying of option contracts is a losing strategy over the long-term, just like roulette.
I’ll talk more about options and safer strategies for their use in later posts.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.