An Introduction to Options

Nov 2, 2006 by Adam C. Powell, Ph.D.

The election is coming up on November 7th. What will this mean for the Dow? Who knows! Say you own some IYY, which today closed at $66.16/share. If you thought the price had a slight chance of going down, you could buy a put option, guaranteeing your right to sell the stock for a predetermined price. If you thought that the stock might go up in price, but did not want a large downside risk, you could buy a call option, guaranteeing the right to buy the stock at a predetermined price.

Options offer the tantalizing opportunity to make small bets pay large returns when stock prices move in your favor. It’s not as easy as it might sound. It costs money to buy options, and if you don’t use them by the time they expire, you receive nothing in return. All options are sold with both an expiration date and “strike price” at which you can buy for a call or sell for a put. Like lottery tickets and horserace bets, options most often finish “out of the money,” giving you nothing in return. If the price never moves, or moves in the wrong direction, your option is worthless.

Why do so many people buy them? A lot of energy is spent graphing ways to “hedge” different types of option bets against each other so that, no matter which way a stock moves, you can’t lose. “Straddles” and “Strangles” and “Butterflies” and “Collars” are among the many colorful terms to describe the endlessly different ways you can combine options to never lose, and always have a chance to win. (Spending just a few minutes on wikipedia.org can show you all the popular methods). So what’s the catch? Like betting on horseraces, you have to wager up front. The price of purchasing your option (or options) is your bet at the window, and your stockbroker is like the person at the racetrack happily taking your bet. Just the same way as you can “cover the box” and be guaranteed a winner no matter which order the horses finish, you can cover all the possible price movements (or no movement at all) with options. But, like with horse races, the cost of purchasing all those options will almost always surpass the payoff, so there’s only so “cute” you can get. So what’s the casual investor to do? The whole reason options were invented was to give serious traders the opportunity to protect themselves and their large portfolios of stock from the whims of the stock market. Some traders buy put options because they do not want to sell their shares right away and expose themselves to hefty capital gains taxes. By a buying a put, a trader could lock-in a sale price, while buying them time for their gain to mature from a short-term gain to a long-term gain.

Capital gains taxes are just one reason for considering options. Perhaps, you don’t want to risk losing money on an extremely risky stock. If you have decided you’re going to buy the stock anyway, you could spend a little extra and buy a put option, so that you will not suffer a loss if the stock goes down. It’s a little extra money, but it can turn a risky portfolio into a conservative one in a hurry, and allow a conservative investor to participate in a new “hot” offering without exposing themselves to losses. Although you won’t make as much money as the high-flyers who purchase shares without a safety net of options, you will be able to sleep more soundly at night.