A Brief Primer on Options20 Nov 2016
Options are a really interesting type of financial security. They are themselves part of a broader group of securities called derivatives. Derivatives, as the name suggests, derive their value from something else. This “something else” can be a stock, the outcome of some event, or even another derivative! Anyway, let’s focus on options, which typically derive their value from the price of a stock.
An option is essentially a contract between two parties that gives the buyer of the option the right to buy or the right to sell some underlying thing at a specified price. This is useful for a few reasons. If I think a stock’s price will go down, I can buy the right to sell the stock at some price and at some point in the future. This price is called the “strike price” and that point in time in the future is called the “expiration date”. The person that sells me this option must buy the stock from me at the strike price, if I choose so. Now, if I’m right and the stock price does go down way below the specified price, then I’ve made money: I can just buy the stock at its current low price and sell it to whoever wrote me the option at the strike price. If, however, I’m wrong and the stock price goes up, or doesn’t go down enough for me to make more money than I’ve spent on the option itself (this is called the premium), then I’ve lost money and the person who sold me the option gets to keep the premium. This is another reason options are useful. In traditional short selling, you borrow and then immediately sell shares in the hopes that the price goes down and you can buy them back later at a lower price. But you must buy them back, so if the stock happens to go up tremendously then you must pay that tremendous price. So in traditional short selling, the downside is unlimited, while with put options, the downside is capped at the cost of the premium.
What I just described was a put option, which gives me the right to sell the underlying. We can also purchase the right to buy some stock at some strike price. This is called a call option. Call options work pretty much exactly inversely to puts: I can buy an option to buy a stock at a certain price, and if that stock goes up way past that price, then I’ll exercise my option and sell it immediately at the higher market price. And if the stock price doesn’t budge or goes down by expiry, then I won’t exercise the option and lose my premium. Now, let’s go through another example, with some actual numbers. Last week, Netflix had its earnings report and its stock soared by over 20%, from about $100 to $126. Now, if I had $1000, I could have bought ten shares of NFLX and made a $260 profit, which isn’t bad. But I could have also bought 200 NFLX call options at a strike price of $100 for about $5 each. That would have netted me a whopping $3000 profit from the same outcome. This is how we can use options as leverage and get a greater return on investment. Of course, there’s no free lunch: I easily could have lost the whole $1000 if the price didn’t go past $100, since there would be no point in exercising the options. Meanwhile, I would have still made some profit had I flat-out bought the shares.
One more thing. There is yet another parameter in options, and that is the style. If the option is American-style, then you can exercise the option anytime until expiration. If the option is European-style, then you can only exercise it on the expiry date. There are other, more esoteric styles, but most people typically use American options.