| Trading and investing in options can be a great way to make money. And contrary to popular opinion, you have to take on a ton of risk to make money with options. In fact, if you use options right they can be less risky than buying your favorite stock!
An Option Is a Contract to Buy or Sell Stock
An option is a contract that gives two people the right or obligation to buy or sell stock at a specified price (the strike price) some time in the future (the expiration date). Each option contract represents 100 shares of its underlying stock and, as a result, gets its value, in some way, from the value of the stock it is attached to.
Options -- like stocks -- are readily available for trade. But like stocks some can be very liquid and some very illiquid. It all depends on how interested people are in the options and its underlying stock.
Buy Calls If You Think a Stock Is Headed Up,
Buy Puts If You Think It's Headed Down
There are two types of options: Calls and Puts. When you buy a call, you buy the right -- but not the obligation -- to purchase stock at a specified price some time in the future. The opposite is true for a put: When you buy a put, you buy the right -- but not the obligation -- to sell stock at a specified price some time in the future.
Since you'd only buy stock if you think it's headed higher, calls are bets that a stock is going up. Likewise, since you'd only sell stock if you think it's headed lower, puts are bets that a stock is headed down.
Options Have Time and Intrinsic Value
Options are priced based on two components. The first component -- and probably the most important -- is the option's time value. The longer the time before the option expires, the higher the option price, all things being equal. Why? Because the underlying stock has a much greater chance of going up (or down) in a longer time frame than in a shorter one. As an option investor, you pay, often handsomely, for that potential price change.
The second component of an option's price is its intrinsic value, which is pretty simple: An option's intrinsic value is based on the amount of gain, or loss, you would make if your option expired today. Here's an example...
Buy ABC Calls and Make 275% in Six Months!
You've done your research on ABC, Inc. and you think the company's stock has big upside potential over the next six months. So, you'd like to get your hands on 1,000 shares. Sure, you could buy the stock outright for $75 a share -- its current market price -- but for 1,000 shares that would cost you a whopping $75,000, a ton of cash by anyone's standards.
On the other hand you could buy ABC call options -- with an expiration date in six months -- for a fraction of the cost. Since you think ABC stock is headed up, you're in the market for ABC call options. You have three alternatives.
First, you can buy ABC's call options that are "out of the money." In our case, that would mean any option with a strike price above ABC's current $75 share price. For this example, let's use ABC options with a strike price of $77.50, or $2.50 out of the money. That option would cost you $6.00 a share. Since all option contracts are for 100 shares -- and you want to control 1,000 shares -- buying ABC $77.50 call options would cost you $6.00 X 100 X 10 or $6,000. That's a stunning $69,000 less than buying the stock and you have the same amount of control, at least for a limited time.
Ok. Let's say you made the right bet and ABC stock goes to $100 a share at expiration. Since your ABC $77.50 call options give you the right to buy ABC stock at $77.50, you exercise your option, buy the ABC stock for $77.50 and immediately sell if for $100 a share, the current market value. That's a nifty $22.50 profit per share!
Now, since you own 10 ABC $77.50 call option contracts -- worth 1,000 shares of ABC stock -- your profit comes $22.50 X 100 X 10 or $22,500. Based on your total cost of $6,000, that's a whopping 275% return in just six months. Nice!
Now, in all likelihood, you wouldn't exercise your right to buy ABC stock. Rather, you'd sell your option just prior to expiration in the open market. Most likely, you'd make the same $22.50 a share.
In our example, we bought ABC call options that were "out of the money". In other words, we bought options with a strike price above the current price of ABC. Since these options have no intrinsic value, only time value, they are the most risky. But as you can see, they can also be the most profitable.
We could have also bought ABC call options that were "at the money" -- options with a strike price equal to ABC's current price -- or ABC call options that were "in the money" -- options with a strike price below ABC's current price. Since these options are closer to ABC's current price, they carry less risk -- and consequently less reward -- than the ones in our example. But they basically work the same.
Now, after doing your research you think ABC's prospects are lousy. So, instead of buying ABC $77.50 call options that expire in six months, you buy ABC $77.50 put options with the same expiration date. Again, you make the right bet and, at expiration, ABC goes to $50 a share. Since you own the ABC $77.50 put options you make the same $22.50 a share -- or a total of $22,500 -- that you would have made if ABC had done to $100 a share and you owned the calls. It's just the other side the coin.
Options Are A Great Tool For Managing Risk
Options have a bad rep. Most people think they are very risky. And while it's true you can lose all your option value, your downside is strictly limited. Let's look at ABC again...
Let's say ABC is trading at the same $75 we talked about earlier and you buy the ABC $77.50 call options that expire in six months. As we said, since you want to control 1,000 shares of ABC, you pay $6.00 X 100 X 10 or $6,000 for 10 ABC $77.50 call option contracts.
Okay. Bad news hits ABC and the stock drops $10 a share. Ugh! Now, if you'd bought the stock outright, you would have instantly lost $10 X 1,000 shares or $10,000, no ifs, ands, or buts about it.
Since you bought ABC options, they will take a hit as well. But since they still have six months to go before expiration-- and the potential of going back up -- they still have value, let's say $2.00 X 100 X 10 or $2,000.
So, the bad news that hit ABC cost stock owners a whopping $10,000. That same bad news cost option owners just $4,000, $6,000 less! Plus, option owners still own the potential of ABC going back up!
Allocate Just 5% To Stock Option Trading
As you can see, owning options can be very profitable and, in some cases, much less risky than owning stock. But that still doesn't mean you can't get hurt trading and investing in options. That's why it's a good idea to allocate no more than 5% of your securities portfolio to trading options. Plus, make sure that 5% is money you can definitely live without.
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Hallaman Market Research
