prepared by Purpose Investments
What are Options?
Options are contracts that allow an investor to buy or sell an underlying security – most often a stock or ETF – at a specified price on or before a predetermined date. Options can be a great addition to a portfolio, providing diversification benefits, a potential source of income, and a way to manage and/or reduce risk.
There are two types of options – puts and calls – and two types of participants – buyers and writers:
How Options Are Priced
The price that a buyer pays for a put or call option is called the premium. Premiums are paid regardless of whether the buyer actually exercises the option or not. There are two key factors that influence the premium:
- Intrinsic value is the in-the-money portion of the premium, or how much the option would “pay off” if exercised immediately.
- Time value is the additional premium amount in excess of the intrinsic value, and reflects the time left until expiration. Generally, the longer the time to expiry, the higher the time value. The most significant influence on time value is implied volatility; the higher the volatility of the underlying security, the higher the premium.
How to Read an Option Symbol
The following is an example of how a call option for fictitious “ABC Company” would look on the options exchange:
Option contracts are typically based on the purchase or sale of 100-unit lots of the underlying security. Likewise, the premium is quoted on a per-unit basis, but the amount payable is the premium multiplied by 100 units.
Benefits of Investing in Options
- Adds a layer of protection to a portfolio
- Can be an additional source of income
- Benefit from stock movement at a fraction of the price
- Risk of loss is both known and limited
Strike price. The price specified in the option contract that the underlying security may be bought or sold for.
Expiration date. The date specified in the option contract, after which the put or call expires worthless.
Option exercise. When a buyer of an option contract, prior to the expiration date, chooses to buy (in the case of a call) or sell (in the case of a put) the underlying security at the strike price.
Implied volatility. The expected volatility of the underlying security over the life of the option. Expected volatility will move up and down with the market’s view of the underlying security’s share price. Generally speaking, the higher the volatility, the higher the premium will be to offset the greater risk the stock price will fall below or rise above the strike price.
In the money. An option is in the money when the underlying security is trading below the strike price in the case of a put, and above the strike price in the case of a call.
Out of the money. An option is out of the money when the underlying security is trading above the strike price in the case of a put, and below the strike price in the case of a call.
If an option is out of the money, its intrinsic value is always zero – there are no negative values.
PUTTING IT ALL TOGETHER
Breaking Down the Premium
On April 25, 2017, ABC170626C00100000 – a call option with a strike price of $100 – is trading at a premium of $11, while the underlying stock, ABC, is currently trading at $110.
Calculating the Payoff
If ABC’s share price rises to $130 before the expiration date, the holder of the option may choose to exercise the option. In the case of a call option, the payoff is positive if the stock price is greater than the strike price (i.e., the buyer can buy the stock at $100, even though it is currently trading at $130).
Using Options in a Portfolio
Investors generally use options for hedging, speculation or income generation. The following are some key ways investors can use options in their portfolio to generate income, manage risk and diversify their portfolios.
Options can be used to help protect a portfolio. For instance, an investor may wish to sell a stock she currently owns, as she believes it has surpassed its target price and now has a significant risk of declining in value. However, for tax or other purposes, she may want to defer the sale until a later date. Alternatively, the investor may intend to continue holding the stock, but is worried about an upcoming earnings report or negative market reaction to an impending economic announcement, such as a possible interest rate movement.
Buying a put option1
Buying a put option, which gives the buyer the right to sell the stock at the strike price, can limit potential losses and provide a hedge against downside risk.
Hold and exercise
Through a hold-and-exercise strategy, an investor buys an option, holds it until the underlying security reaches an optimal price, and then exercises. This strategy provides limited risk (i.e., you can only lose the amount paid for the options) and the potential for unlimited reward (i.e., no matter how much the stock rises, in the case of a call option, or falls, in the case of a put option, the option holder has the right to sell or buy the stock at the strike price).
In addition to hold-and-exercise strategies, investors often buy and then resell options before the expiration date, profiting from any increase in premiums. Like stocks, options are traded on securities marketplaces, and like stock prices, option premiums move up and down according to valuation and other factors.
More sophisticated investors may use strategies that include put writing as a means to generate income. However, note that while the put holder has the right to sell a stock, the writer has the obligation to buy it if assigned. This substantially increases the writer’s risk of a loss.
Frank has researched and ranked a number of companies to generate a shortlist of what he believes are the 20 highest-quality U.S. stocks with the most upside potential. However, rather than buy the shares directly at a considerable upfront cost, he decides to park his cash in a high-interest savings fund and generate income by writing out-of-the-money put options on his selection of stocks.
If the prices of the stocks remain above the strike price at expiration, Frank generates income and writes new puts on the same or new stocks. However, if the stock price falls below the strike price, and a buyer exercises his or her option to sell the stock, Frank will need to use some of his cash to purchase the stock at the strike price. At that point, he can (i) sell the position, (ii) write a call or buy a put on the stock to limit further losses, or (iii) continue to hold it, if he believes there is still upside potential.
Writing a Covered Call Option
Writing a call option on a security already held (a “covered call”) can provide a source of income, and even in some cases help hedge against downside risk. However, it’s important to remember that the call writer must sell the stock at the strike price, if the option buyer exercises his or her right to buy the stock.
- Selling an out-of-the-money call (i.e., the strike price is above the current stock price) will generate a small amount of income and provide room for the stock to rise before a potential exercise.
- Selling an in-the-money call (i.e., the strike price is below the current stock price) will generate income, but the call writer is more likely to be called away, and must be prepared to sell the stock at the strike price.
- Using a collar strategy (i.e., selling a call option and buying a put option on the stock held) can provide downside protection, but investors should also be aware that it limits the upside potential as well, if the entire position is collared. One solution may be to collar only a portion of the holding.
Writing an Uncovered Call
Some investors may also use an uncovered call writing strategy, which involves writing a call on a stock that they don’t own. However, this type of strategy carries substantial risk: in the event that the underlying stock appreciates significantly against the strike price, the call writer will need to buy the stock at the current higher valuation only to sell it to the buyer who exercised the option at the much lower strike price.
1The examples in this document are for illustration purposes only, and do not include costs such as broker commissions, taxes, and any other associated expenses.
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