Last week, we went through the basics of options with you. What types of options there are, how they’re priced, and ultimately what purpose they serve. If you missed it, take a skim through part 1 before you read this.
Seriously, read part 1. You’ll need that information.
We wanted to offer something that’s a bit more advanced for those among you who are keen to read an internet textbook on finance (if it was written by the coolest investors you know).
Now that we have that down, we’re going to look at two different scenarios, each explaining how the option transaction would work, with theoretical stock price movements to reflect how options perform as a financial instrument. We’ll refer to the first scenario as Speculation, and the second we will call Insurance.
Options as Speculation Tools
Let’s look at speculation–style option trading,
Two people engage in options trading. Person A wants to buy a call option. Person B wants to sell a call option. The underlying company, called ABC Ltd., is currently trading at $10/share and neither Person A nor Person B owns the stock. Person A is buying a naked call, and Person B is selling a naked call.
Call options that grant you the right to buy ABC Ltd. at $12, expiring March 5, are currently selling for $1; purely consisting of time value. Person A wants to buy 10 call options (which is 10 contracts, consisting of 100 shares/contract), as they think the stock will move upwards. Person B wants to sell call options, as they think the stock will move downward. Person A buys 10 call options for a total of $1000 (1000 shares x $1/share) “from” Person B. After the transaction has gone through, neither party now owns common shares of the underlying stock. They did not own them before, and they do not yet own them. Person B has collected $1000 from Person A, in exchange for the obligation to sell Person A 1000 shares for $12.
If ABC Ltd. moves up 50% to $15 a share, Person A’s position would be worth an extra $3/share in intrinsic value. 10 contracts, at 100 shares/contract, is 1000 shares controlled by the contract. This would add $3000 to the value of Person A’s position, before any time value that may still be deducted as the contract comes closer to expiry.
You may want to read this over again once or twice, as it can take a moment to get everything straight.
Notice how the stock price only increased by 50%; however, Person A’s position has increased by 300%. This is the magic of options trading. If Person A were to spend $1000 on ABC Ltd. stock instead, they would have been able to buy just 100 shares at $10/share and sell their shares for $1500 at $15/share. However, Person A spent $1000 on ABC12 Mar 5 options instead, turning their $1000 into $4000 (less time value decreases) from the same price movement.
Higher reward also brings higher risk: if ABC Ltd. fell 50% to $5/share, the value of Person A’s position would drop drastically, depending on the time value priced by CBOE, it would be somewhere around $100-$250. A potential 90% loss, whereas if Person A had simply invested $1000 in common shares of ABC Ltd., they would only harbor a loss of $5/share, or $500.
In the scenario that ABC Ltd. increased to $15, Person A can either sell the contract for around $4000 as discussed or exercise his right to buy ABC Ltd. at $12/share.
If they were to do the latter, Person B would now have the obligation to sell Person A 1000 shares of ABC Ltd. at $12/share. As Person B performed a naked put, they would have to go and buy these 1000 shares in the open market for $15/share before selling it to Person A for a $3/share, or $3000, loss. Because Person B already collected a $1000 premium at the time of initial transaction, their net loss would be $2000.
On the other side of this scenario, Person A would proceed to exercise their right to pay $12,000 for 1000 shares of ABC at $12/share, and instantly sell them for $15,000 at market price, which is $15/share. This would bring Person a $2000 net profit, after considering the $1000 they spent on the call option. This gives you a 100% return on a stock that has only moved 50%.*
- Whether to sell your contract or exercise it is your choice as the option holder. The profitability in both scenarios may vary depending on how much time is left in the contract, as well as price of the underlying stock. We’ve just used whole numbers because, well, this is complicated enough already.
In this scenario, Person B had to fork over $15,000 to buy shares, only to sell them for $12,000, as they have been exercised by the option holder. This, and the potential for magnified losses, is the frightening part of speculating with options. You must trade wisely when it comes to these.
The good thing is: any option you buy can be offset by selling the same type of option at the same strike price and expiry. This is a common method for reducing risk when a contract trends in the opposite direction from what you have anticipated.
“That’s A Lot of Risk... I’m Looking to Actually Reduce Risk in My Portfolio. Can I Use Options to Achieve This?”
Yes, theoretical questioning voice in this headline, you can. We thought you would never ask.
We’re going to take you through a method that famed investor Mark Cuban used to insure his portfolio during the turbulent tech bubble of the early 2000’s.
Using options as insurance to hedge risk in your portfolio can be achieved if you buy or sell options on stocks you already own. Let’s run though some examples. We are going to keep the exact numbers vague as to not overload this article with too many numbers. All pricing is hypothetical.
This strategy involves:
- owning stock,
- selling calls on that same stock, and then
- using the premiums to buy puts on that stock.
Now that you’re scratching your head, let’s begin.
Person A has owned 1000 shares of DEF Ltd. since they were $5/share, and the company now sits at $10/share. Knowing there could be volatility in the markets this year, Person A wants to hedge some of their risk. A common way of doing so is selling call options.
Person A can sell the right to buy DEF Ltd. at $10, by selling (also known as writing) 10 DEF10 Aug 7 call options priced at $4, earning Person A a $4000 premium. Person A now has an obligation to sell 1000 shares of DEF Ltd. to the call buyer.
This is no problem, as Person A already owns 1000 shares of DEF Ltd., which they would be happy to sell for $10 a piece, as this earns them a 100% return on their initial investment!
Now, the $4000 premium that Person A collected will go towards buying puts (a.k.a. the right to sell shares of DEF Ltd. at a fixed price) at a strike price that is ideally higher than what Person A originally acquired DEF Ltd. for.
Person A finds out that DEF10 Aug 7 put options are going for $4/share on the market. This would give Person A the right to sell 100 shares of DEF Ltd. at $10/share. Having $4000, Person A proceeds to purchase 10 contracts of DEF10 Aug 7 put options.
Let’s stop for a second to take inventory. Person A has:
- 1000 shares of DEF Ltd., which are worth whatever the market says they’re worth,
- the right to sell another 1000 shares at $10/share,
- and an obligation to sell 1000 shares at $10/share if the options contract buyer decides to exercise their right to buy them.
If the DEF Ltd. stock price pulled back to let’s say, $6/share, Person A can still exercise the right to sell shares of DEF Ltd. on the market for $10/share. (Note that, at this price, Person A wouldn’t be exercised on the call option they sold to the call buyer, since nobody wants to exercise their right to buy a stock at $10 when its only selling for $6.)
Person A originally bought these 1000 shares for $5/share, so this nets Person A a $5000 profit, or $5/share. Person A didn’t spend a dime of their own money on these put options, as they sold call options to receive the capital to do so.
Should DEF Ltd. increase to $12 instead, the holder of the call options that Person A sold (which are now “in-the-money”) may exercise Person A on their obligation to sell those shares to them for $10/share. As you can see, even though this limits the upside, it has dramatically decreased the downside for Person A. Talk about getting a better sleep at night. This strategy allows Person A to lock down their $10/share exit position until their option contracts expire, leaving them to continue to hold the stock and reach higher targets, where they can hedge again and repeat.
In conclusion, depending on where you are in your investing journey, options could mean a bold trek through the world of high-risk, high-return investing in order to grow your capital aggressively, or simply a means of insuring any current positions you have. There are many scenarios where options can be used creatively – and these are just a couple of them.
As you continue to grasp the concept, you will start seeing a place for options almost everywhere in a portfolio, whether it’s to hedge a large portion of your holdings for insurance, or to speculate and grow a small portion of your holdings in the riskier portion of your portfolio.
Use wisely and if you’re new, it might be best to not trade options in which you don’t own the underlying stock. Remember, don’t get caught with your pants down.