What Are Options?

You can earn money in the stock market in several different ways. Some investors buy huge amounts of stocks of corporations in the hopes of high quarterly dividends. Some investors buy and sell stocks and profit at the difference between the selling and buying price. Others engage in forward contracts and future contracts.

However, investors understand that the ownership acquired through the buying of stocks not only places them in a position to earn but also brings them a corresponding, and sometimes insurmountable, amount of risk. For instance, an investor decides to invest thousands of USD in buying the stocks of Company X. After a month, the company reveals that it has incurred major financial losses and will be preparing for liquidation soon. In this scenario, the investor takes in huge losses.

If you want to earn from the stock market but at the same time limit your potential losses, then you ought to consider the buying and selling of options.

But first off, what are options?

Options Defined

Options are a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before an agreed date. Option Contracts are one form of derivatives because the value of the contract is derived from an underlying asset.

Types of Options

Options have two types: a Call Option and a Put Option.

A Call Option gives the holder the right to buy the underlying asset at the strike price on or before the expiration date. Holders of a call option expect that the price of the underlying asset rises on or before the expiration date.

A Put Option gives the holder the right to sell the underlying asset at the strike price on or before the expiration date. Holders of a put option expect that the price of the underlying asset falls on or before the expiration date.

Illustrative Example

Let us say that you expect that the price of Corporation Y will rise after one month. You do not own any share of Corporation Y so you talk to a friend named John. John holds 100 shares of Corporation Y. At that time, the shares of Corporation Y are fairly valued at $40 per share. Then, you convince John to enter into a contract on February 15, 2013 to sell you his 100 shares of Corporation Y at $43 on or before March 15, 2013. Of course, John is not going to do this for free so you pay a fee of $300.

In the example above, the contract entered into between you and John is called an option, more specifically a Call Option. The underlying asset is the stock of Corporation Y.  The fixed price of $43 at which you can choose to buy the 100 shares from John within one month is called the strike price. The fee you paid to John is called the premium.  The date at which your right to buy the shares at $43 expires, in this case March 15, 2013,  is called the expiration date.

Now, let us assume that the price of Corporation Y goes up to $55 before March 15. When this happens, you can exercise the contract. This means, you can buy 100 shares of Corporation Y from John at the agreed price of $43 for a total of $4300. Then, you can immediately sell the 100 shares you bought from John at the market price of $55 for a total $5500. Your profit will be $5500 (from selling the shares) minus $4300 (from buying the shares) minus $300 (the premium paid). You have earned $900 in just a few weeks.

This time, let us assume that the price of Corporation Y plummets to $30. When this happens, you can choose to ignore the options contract. There is no point of buying the shares of Corporation Y from John at $43 if you can simply by the same shares from the market at a cheaper price of $30. This means that at this point the options contract becomes worthless and you incur a loss which is the $300 premium you paid to John.

Notice that in the second situation, you did not buy the 100 shares of Corporation Y at $43 from John even if there was a contract between the two of you.  This is due to the fact that the option contract gives you, the buyer, a choice. That is why it is called “option”. You can choose to exercise it or not depending on whether the market price is on your favor.

A summary of the illustrative examples we had is shown below:

Also notice that if you did not buy the option but instead bought the shares right away at a price of $40 on February 15, you would have incurred major losses when the price fell to $30. You would have carried a loss of an amount equal to $1000. Hence, options are a way of hedging your losses while giving you the opportunity to anticipate returns.