Options are often misunderstood, as they can be used for multiple purposes. Many investors use options to provide leverage for additional returns, which adds extra risk to portfolios; however, one of the easiest ways to describe options is as a form of insurance when purchasing a specific stock. As a type of short-term insurance contract, options provide the right to buy or sell a specific stock at a specific price in the future.
There are two types of options, calls and puts. Each type is a contract, which can be either written (sold) or purchased. Let’s take a look from the buyer’s perspective –
Call Option – When call option is purchased, the buyer is buying a contract that allows them to purchase a stock at a specific price in the future.
- John buys an option to purchase 100 shares of Apple stock in the next three months for $100/share. When he makes the purchase, Apple is trading at $95/share. If Apple stock jumps up to $105/share, John has the option to purchase it at the $100 price. He can then immediately sell it for $105 to make a profit. If Apple stock were to slide down to $90/share, John would forego using the option, and let it expire. His total cost would only be the premium he originally paid for the option contract.
Put Option – A put option gives the buyer the right to sell a specific amount of shares at a specific price in the future. Let’s take a look at the same example as above, but with John buying a put instead of a call.
- John believes Apple stock is going to fall, so he purchases put options for $90/share when Apple is trading at $95/share. If Apple were to fall to $85, John could purchase the Apple shares and exercise his right to sell them at $90. If Apple continues to trade above John’s target, the option will expire and John will be out-of-pocket the premium he paid to the seller, or writer.
The original seller, or writer, of the examples above is on the opposite side of the trade. A seller of a call option is generally bearish and expects the stock price to fall, while the seller of a put is generally bullish and expects the stock price to rise. When an investor also owns the underlying stock the option is based upon, multiple strategies become available.
Insurance – Options can be used as a form of insurance to protect against losses. When owning the underlying security, a stockholder can purchase a put that limits their downside price. Let’s take a look at another example.
- John is working for a bank before the market crash of 2008. He has been purchasing discounted shares on a regular basis through the employee stock purchase program. His net worth is starting to be heavily invested in the company he works for, and he would like to protect some of it against a downturn in the event of his stock falling. John starts purchasing put options at a price below the current trading price. If the stock is trading at $50, and his option price is $48, he is limiting his downside loss. If his stock were to lose 20% and fall to $40, John can sell the position for $48, limiting his loss to 4%. In the event this doesn’t happen, John’s premiums acted like an insurance policy, giving him the peace of mind knowing he was able to protect his investment. In the event John didn’t want to pay for the premium, he could write, or sell call options above the current trading price. The premium he receives will be used to purchase the puts. The downside is that if his stock jumps above his target price, it can be “called” away from him, in effect limiting his upside potential. This is a small price that John is willing to pay to protect his investment.
We’ve highlighted a few popular uses for options, and they can be used in other strategies as well. Make sure you make informed decisions before using options in your portfolio and consult with your trusted advisor.