By Jason Jubas
Options are one of the riskiest investments an investor can make. An option is an asset that gives the buyer the right, but not the obligation, to purchase or sell a specific underlying asset at a precise price at or before a certain date. Each option contract typically represents a hundred shares of the underlying asset. The two most common types of options are known as calls and puts. A call allows the buyer to purchase a hundred shares of a specific underlying asset at a predetermined price and set date, while a put allows the buyer to sell a hundred shares of a specific underlying asset at a predetermined price and set date. Options are used in a variety of ways such as hedging, to earn extra income, for tax purposes, and most dangerously, for speculation.
A common objective for most portfolios is to have the largest gain with the smallest amount of risk. Options play a huge role in minimizing risk by providing downside security. For example, if you owned 100 shares of Apple at its current price, say $500, and you are risk averse, in a shaky market you can buy a put option on Apple with a $500 strike price. Now if Apple goes down $50, you would lose $5,000 on your actual Apple shares ($50 per share at 100 shares), but you would make $5,000 on the Apple put, essentially canceling out the drop in price. However, if Apple went up $50, you would make $5,000 on my Apple shares and you would not lose $5,000 on the Apple put because you do not and should not exercise your right to sell your 100 shares on Apple at $500, while you are able to sell your Apple shares at $550 on the current market. However, you would lose out on the premium (cost) of the put. It is important to know that this scenario does not bode well with a stable market where you could very well lose the money of the option, but not make any money on the actual Apple shares itself either.
A second reason investors use options is to earn extra income in a very calm market. Say you own 100 shares of Apple at $500 and you think in a month Apple will still be at $500 or very close to its current price. You can sell a call for Apple at $500, earn the premium from the cost of the option that you sold, and even if Apple goes up $100, you are covered since you own 100 shares of Apple, which will pay for the call that you sold. The official terminology in the finance world of this method is called a covered call.
A third reason investors use options is to evade paying higher taxes. Because short term gains are taxed at a much higher rate than long term gains, many investors will hold onto large short-term gains and buy options in the opposite direction; essentially hedging out their position without officially realizing a gain. For example, if you are holding onto a $100,000 gain on the 1,000 Tesla shares that you own, it is wise for an individual in a high-income tax bracket to purchase 10 puts on Tesla. This would neutralize their position without officially closing out their position and realizing their gain until it becomes a long-term gain, which depending on their tax bracket, could save them a significant amount of money.
A fourth and extremely risky use of options is for speculative buyers and sellers. If you really have a feeling that a company or even the market as an entity is going to go up or down within a certain period of time, you can purchase or sell options without having any underlying positions. This is extremely risky as many times options expire worthless. If you buy a call for Apple at $510 for the end of the week and Apple is only at $505 when the expiration date has arrived, your option is worthless since there is no reason to pay $510 per share of Apple when you can buy Apple shares on the market at only $505, thus losing the entire value of the option. This strategy works best in volatile markets and assets.
Each option has two components to it: the time premium and its intrinsic value. The time premium represents how much the option is worth based on the time remaining until expiration. The closer the option is to expiring, the smaller the time premium portion of the option will be. On the other hand, the intrinsic value represents how much money the option is worth if the option were to expire or be exercised immediately. As the option moves deeper and deeper in the money, there is less risk that the option will expire worthless and will be mainly comprised of the intrinsic value. Options out of the money will be comprised of only the time premium value, while options deep in the money will nearly be comprised of intrinsic value. The Greek letter Delta contains a value between zero and one and it tells you how much the option moves in value relative to the moves in the underlying asset. The Greek letter Theta tells you how much value you are losing each day due to time decay on the option. Understanding how both Delta and Theta move as the underlying asset moves is crucial for option trading.