Options are powerful. And there’s a lot to understanding them.
Call options give us the right, but not the obligation, to buy something at a specific price within a certain time. They don’t cost as much as the underlying stock, but they benefit just as much when the price goes up. As a result, there’s a lot of implicit leverage in an option. An option on a $100 stock might cost you $3. If the stock goes up 3%, the option price could go up almost 100%.
The same works on the downside. Put options give us the right, but not the obligation, to sell something at a specified price. That’s why people use them to protect their portfolios, in case the market sells off. Put options are like insurance. There’s a premium – the option price – and they provide protection if we have a downturn.
Given their potential, why doesn’t everyone use options to invest? After all, the upside seems limitless, and the most you can lose is the premium – the funds we pay to buy the option. But there’s a major issue: every option has an expiration date. When we buy a call or a put, there’s an expiration date for those options. They’re only good for a specific time period. If that time passes and the price is out of the money, that option will expire worthless. When you own options, time is not your friend. There’s always a cost to waiting.
Illustration: Koltepranita. Source: Wikipedia
In addition, the implied leverage in an option can cut both ways. That $3 option may get a big move to the upside, but it can move down just as quickly. The downside may be limited to 100%, but that’s still a pretty big number. If options are 3% of our portfolio, having them expire worthless means we’ll have a 3% loss.
Buying or selling options may be useful in our investment portfolios, but there are some securities that have options built into the securities. Understanding options as stand-alone instruments can help us understand how embedded options work in bonds, mortgages, stocks, and real estate. And maybe help us invest a little more profitably.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”