The One Option You Do Not Need
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“Most strategies used by options investors have limited risk but also limited profit potential. Options strategies are not get-rich-quick schemes.”
The Options Industry Council (OIC)
I debated writing about financial options for a long time.
The reason I bring options up now is the focus on the trading application Robinhood. Robinhood offers option trading and margin accounts. As do most brokerage firms.
It appears that Robinhood clients were given easier access to options trading than other brokerage firms allow.
I suspect I know why but the unfortunate results are now known as inexperienced investors lose money.
If you have recently started investing, or you are going to open a brokerage account you may be given an option to trade options.
If given the option to trade options you choose “No”. Same thing for a “margin” account. “No”
I strongly believe that very few people can learn how to trade options on the fly without significant experience trading stocks or bonds.
Kind of like performing for Cirque du Soleil. Options trading is fast. Timing is critical. You must watch every move to get it right.
The investors who use options are typically investment managers of mutual funds, financial risk managers, hedge funds and institutional investors.
When used correctly options can provide significant benefits and returns to portfolios.
When used incorrectly options can cause serious losses.
Ask any newbie Robinhood investor who thought “they can’t be that difficult.”
If you own any actively managed equity mutual funds, the managers of the fund are probably using options.
So, what exactly are they?
Options are contracts. The contract is between a buyer of stock (me) and a seller of stock (you).
Every option has features just like we have features that make us recognizable, our eyes or nose or mouth.
Features in an option contract include an agreed upon stock price, a price for the option, a specific date in the future and exercise!
Yes those little options are going to get exercised.
Here are the basics:
One option contract equals 100 shares of stock.
I am interested in XYZ company and want to buy 100 shares. I think the price is going to go up so I want to lock in a price today before the price goes past what I want to pay.
You own 100 shares of XYZ company, and you think the price of the stock will go down. You want to lock in a price at which you will sell your stock and still make a profit.
I am going to pay you for the option (the right) to buy your stock at a specific price , on or before a specific date.
The amount that I pay you for one option is far less than the cost of 100 shares. It is called a “premium”, like the premium you pay for an insurance policy.
Low cost is one of the features that make stock options attractive. Options require less capital than buying stock outright.
You have now received income from selling me the right to buy your stock at a price we have both agreed on and a date we both agree on.
Let’s say the price we agree on is $60 per share.
I want to buy the stock for $60 and you want to sell the stock for $60.
What neither of us knows for sure is what price the stock will be on agreed upon date.
The date arrives. The nail-biting moment. Also known as the expiration date. Like a carton of milk.
And then, we watch as the stock price reaches $65 per share.
I call you and say “Hey, did you see what our stock did today ? It is higher than $60”.
You sold me the right to buy the stock at $60, even though it is now $65.
I exercise my right and buy the 100 shares at $60 per share.
Are you angry? Upset that you sold the stock too soon?
Not at all. You bought the stock at $30!
You have watched the price steadily increase. You decide that selling your stock at $60 is a great return on your investment. Plus, you get to keep the premium.
Or this could happen:
On the option expiration date, the closing price of the stock is $59 per share. The option is only valuable to me if it is above $60.
My option expires worthless. Another name for worthless? “Out of the money”. Yep, I am out of the money all right. You keep the premium and you still own the stock.
Anyway, why would I buy the stock at $60 when I can buy it at $59 ?
The example I have given you is a very basic introduction, intended to give you a concept of what an option is.
But options are complex financial instruments. You don’t need options to be a successful long-term investor.
Here is a short list of the terminology I used in this article:
- Buying an option that gives you the right to buy stock is called a CALL option. Like I’m calling your stock away from you.
- When I use the option to buy your stock, I am EXERCISING my option.
- The price of the stock the buyer and seller agree on is the STRIKE price.
- The day the option expires is called the EXPIRATION date.
- The price of an option is called the PREMIUM.
The following are trusted resources for learning more about options:
Options Education – What is an Option ?
Chicago Board Options Exchange
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
