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Many investing portfolios include securities such as stocks, bonds, and mutual funds – but there are vehicles that can be included as well. Options trading is one, a more advanced and sophisticated way to generate income and/or capital gains. To see if options are a good fit for your investment portfolio, here are the basics of what options are, why investors use them, advantages and disadvantages.

 

What are Options?

Options are different from other types of investment instruments because they are financial contracts based on factors that include factors that are other than the actual value of an  “underlying” security (stock). Options are a form of derivative, which means that they principally derive their primary value from another asset. Factors determining value include intrinsic value of the equity (underlying), time value (time to expiration), volatility of the underlying security as well as some minor components. This form of investment offers many different ways to make profits from the price movements of a range of assets and securities over a specific timeframe.

At its simplest, an option allows you to bet on whether the price of a stock will go up or down. The purchase (BUY) of an option means you’re buying the RIGHT (but not the obligation) to buy a specified quantity of a security within a specified period of time until a specified date (Expiration). You can do many things:

  • Buy or sell shares of a stock at the agreed-upon price (the “strike price”) for a limited period of time.
  • Sell the contract to another investor.
  • Let the option contract expire and walk away without further financial obligation.

 

The sale or writing (SELL) of an option means you are PROMISING (obligation) to sell a specified quantity of a security at the end of a specified period of time (Expiration), at a specified price IF the option is “exercised”. (Execution of the right of the holder of an option who exercises their right to purchase the underlying security). The seller of these contracts is paid an agreed amount of money to make this promise and keeps it if the contract is exercised or not. (This is known as the “premium” and is essentially compensation for the risk the seller of the contract takes on.)

 

Use of Options

Advantages

There are many different reasons why an investor may use options trading. A favorite reason why options trading is used is that an option can protect investors against downside risk by securing in the price without the obligation to buy. Other reasons why options trading is favored over the outright purchase of an equity is because an option buys an investor time to see how things play out and buying an option requires a smaller initial outlay than buying stock (Lower risk). One can participate in the upside of an equity without laying out funds to actually purchase the equity. (Think Amazon at $1,598/shr!!) Another  favorite reason for those who are risk averse but want income is the “sale” of options to generate income by way of being paid “Premiums” (See above). Options trading also offers tremendous flexibility. This is in contrast to direct investment, where there are limited strategies involved and limited ways to make money.

 

Disadvantages

All investments are associated with some risk and downside. Options trading is hard to master. The complexities of options trading can seem overwhelming or even intimidating compared to other forms of investment. Starting simple and not making big bets is the best way to start off. Paper trading is better still. Profits through the Purchase (Buy) of options can be made, but it does risk your purchase price, and takes times and commitment.  Options can be used to limit risk, but only if you understand the strategies required.

Options trading is an excellent and sophisticated investment form to generate income and capital gains. Although commitment and time are needed to make money, the payout can be worth it if you take the time to understand what options trading is all about.

 

This article is intended as a brief introduction to options trading and not a comprehensive resource. More detailed articles will follow from time to time.

 

Robert Desai is an established equities investor located in the Greater Boston Area. Read more of his investment blogs or check out his Twitter!