An option is a financial derivative that gives the holder the right, but not the obligation to buy or sell a financial asset at a pre-determined price during a pre-determined period. The issuer of an option has to comply with the wishes of the option holder, regardless of whether it is a financially good deal.
There are two kinds of options:
- Put – the option to sell
- Call – the option to buy
Options are used as a means of hedging or of relatively leveraged speculation (this is not leverage in the usual form as there is no requirement to borrow money and the losses are limited, but the potential returns are higher than with other investments).
There are 3 key terms to know when considering options:
- Strike Price – the value at which the shares can be sold (i.e. $200), regardless of the current market value
- Exercise Date – the date by which the option has to be exercised or expires
- Contract – the contract of an option provides the buyer with exposure to 100 shares. The price of an option is always per share amount so the cost of the contract will be multiplied by 100
An example of how options work is as follows:
- Investor A sells Investor B a put option on Morgan Stanley for December 2012 at a strike price of $15 per share, for a cost of $0.05 per share ($5 total).
- If in December 2012 the value of Morgan Stanley shares is $17.50, then the option is worthless. Investor A has made $5 and Investor B has lost the value of the options ($5).
- If in December 2012 the value of Morgan Stanley shares is $12.50, then the option has value. Investor A has lost $245 (the difference between 100 shares at $15 and at $12.50, plus the $5 from Investor B).
- In the second scenario, Investor B has made $245 (the difference between the market value of $12.50 and the option share value of $15, minus the $5 paid for the option.
The hard part about using options is that there is a time factor included. It is not enough to merely predict that the share price will rise or fall, you must also predict when it will do so.
Options are often preferred to buying shares outright in the market due to the fact that the maximum loss is less than on shares, and the return percentage is much higher. An example to illustrate this is shown below.
- Investor A buys 100 shares of Apple at $375 for a total cost of $37,500
- Investor B buys a call option for March 2012 on Apple with strike price $400 for a total cost of $500 ($5 x 100)
- In March 2012 the price of Apple shares is $300
- Investor A has lost $7500 ($75 x 100)
- Investor B has only lost his maximum amount of $500
- Now assume in March 2012 the price of Apple shares is $500
- Investor A has made $12,500 profit ($125 x 100) that is a return of 33%
- Investor B has made $9,500 profit ([$500 x 100] – [$400 x 100] - $500) which is a return of 900%
This shows how options provide improved returns and reduced maximum losses over buying shares; the risk is that options can easily expire worthless whereas shares usually still have value.
- Exercise Date
- In The Money
- Out Of The Money
- Put-Call Parity
- Strike Price