Options, What Are They?

This was something I wrote on my underutilised blog a couple of years back and shared on FB with the Seedly community.

Been a while since I wrote stuff so hope to hear some feedback from you all. Looking to add more content, especially on the different strategies in the near future. Only thing hampering is the graveyard shift taking care of a 9 week old infant.

So, what are options?

It's a form of derivative contract on stocks (including ETFs), forex, futures, etc. It’s price is dependent on the underlying product, e.g stock. Similar to how wine is a derivative of grapes.

It has an expiry date, with different strike prices arranged under Put and Call types. And you can buy and sell under each type, which allows for complex strategies to be used.

Each option contract represents 100 shares of the underlying stock it is derived from. A strike represents the price of the underlying stock that you wish to transact the option contract at.

An example of an Option Chain as seen from TD Ameritrade’s desktop platform for Tesla (TSLA). Do open the image in a new tab if it's too small.

This shows a few things. The expiry date, the strikes available arranged under Puts and Calls and the premiums (prices) for the different strikes. The prices under each Bid (sell) and Ask (buy) are on a per share basis, so it needs to be multiplied by 100 for each option contract. For example, the 600 long put is priced at 0.25 in the image. This means you pay $25 (before commission) per contract to open the position. Remember, you need to multiply the premium by 100 to get the price you need to pay. So if you open with 2 contracts, you need to pay $50.

Usually I'll aim for the middle price between the bid and ask, so it will be possible to transact for about 0.24 or $24 per contract in this case.

Common Uses

Options are flexible in nature, and can be used to hedge your stock positions, short a stock or gain extra income from your stock holdings outside of receiving dividends. Also it may allow for great profits compared vis-a-vis to just holding stocks.

Hedging

Say you have a $100,000 position on one stock and you are concerned about bad news during the upcoming earnings announcement. You can buy a Put option (hedge) on your stock holdings to protect against the downside. E.g. The current stock price for TSLA is $745 and you are concerned about it dripping below $700. You buy a Put option at $700 strike at about $2.52 (*100 = $252 per Put contract). So $45/share is the max amount you will lose if things go south after earnings.

So let’s say the price drops to $650 after earnings. You can choose to exercise the Put option you bought (provided it has not expired) and your stock holdings will be taken away from you at $700/share, protecting your holdings from further downside. You can also choose to just sell away the Put contract for profit and leave the stock position “un-hedged”. This only works if your stock holding is in multiples of 100 shares.

Flip side is if the stock rises or stays above $700 by the expiry date of your Put option, it will expire worthless. You will need to buy another Put option with a new expiry date if you wish to continue hedging your stock holdings.

If you don’t own the stock, you can still buy a Put if you are bearish on the stock (effectively, shorting). In the above example, you can buy the TSLA $700 put if you think TSLA can close at or below $700 by the expiry date.

If the stock price drops below your strike, you can either sell off the Put for a potential profit or exercise it before expiry. The latter will result in a negative amount of shares credited into your account (i.e. -x00 shares where x is the number of contracts exercised). If the stock price drops further you can close the short position for profit.

Covered Calls

An alternative way to earn income using your existing stock holdings on top of the dividends (if any) you receive as a stock holder.

How it works is that you can sell a Call option on your stock holdings at a strike that is above the current price. You will get paid a certain premium amount, depending on the Call strike selected and how far till expiry it is from today’s date.

If the stock price does not cross your chosen strike on expiry, you keep the premium amount and the stock and you can choose to sell another Call option for a later expiry date.

If the stock price does cross above the strike on expiry day, you keep the premium but your stock will be taken away from you. Your profit will be the premium you collected from selling the Call option plus the (potential) realised gains between the strike price and the price you paid for the stock.

Naked Calls

This is like the opposite of hedging, where you believe that the stock price will rise within a certain period and you wish to participate in the upside. You can either buy the stock outright and sell it off later for gains, or you can just pay a fraction of the stock price and buy a Call option.

For example, stock is currently trading at $150 and you believe it will rise to $175 and above soon. You can buy a Call at $170 strike and pay $0.20 (100 = $20 per Call contract) and wait. If the share price rises above $170 before the expiration date of the Call option, you can sell off the contract for potential gains, or exercise the option to buy the stock at $170 per share (100 shares per Call option = $17,000 capital required).

Bull Puts

You open a bull Put position through selling a Put option at a strike that is below the current stock price. Say the stock you are selling the Put on is currently trading at $45. You sell a bull Put at $42.50 strike and collect $0.20 (*100 = $20 collected per Put contract). Come expiry, if the stock stays above $42.50, you keep the premium collected and the Put option expires. You can then sell another Put option to collect more premium.

If the stock price drops below $42.50, your option gets exercised and you pay $4,250 to purchase 100 shares of the underlying per Put contract sold. This can be a way to purchase stock at a discount from current prices AND you get paid to wait for the option to be exercised.

This can be part of a "wheel" strategy where you sell to open put positions and you get assigned. You then sell covered calls to reduce your cost basis of the stock assignment. If the stock price is above your call strike price at expiry, your shares get taken away. Rinse and repeat.

Concluding Thoughts

Options deserve a place in your portfolio. Not only as a hedge or as an additional way to earn money from your existing stock holdings, but also as a pure trade play to supercharge your portfolio returns.

There are a lot of strategies that are used out there besides simple puts and calls, like iron condors, verticals, diagonals, butterflies (my current favourite) etc. I'm looking to explore these in another opinion piece soon.

Options can be risky if you don’t know what you are doing as you may be exposed to unlimited liability. Hence, exercise prudent risk management through the use of spreads to limit your max losses and limiting the number of positions you open. Paper trade if you are not sure if your trade idea works.

Hope this write up gives you an idea of how options can be used. My portfolio is focused in the US market but options are also used in other markets like the London Stock Exchange and Australia Stock Exchange.

Let me know what you think in the comments below.

Reference(s):

https://www.investopedia.com/options-basics-tutorial-4583012

Disclaimer: The above article represents my own viewpoints and are meant for educational purposes only.