Investing in Options
Options are an investment vehicle that offer a bit more sophistication for the average investor. They can be hard to understand and I will try to explain it in more detail here.
What Is An Option?
An option is the right, but not the obligation, to buy or sell a set number of shares of a stock at a specified price (called the strike price) during a specific period of time.
A call option is the right to "buy" and the put option is the right to "sell".
Here is an example. I looked on the exchange today (Dec. 6, 2006). Nortel Networks (NT) was trading in Canada for $25.20/share. There was a call option selling on the options exchange for January 2007 with a $25.00 strike price for $1.60/share. What does this mean? If you buy this option contract it will cost you $1.60/share. One contract is 100 shares so you will have to pay $160.00 plus commissions to your brokerage. You then have the option to buy Nortel shares for $26.00/share between now and the the 3rd Friday of January (because it is a January contract).
Now you would ask, "Why would I want to do that? It is only $25.20 right now anyways." That is true, but what will it go to by the time it expires? You could buy the stock right now, but you would have to pay 100 X $25.20 or $2,520. That is a lot of upfront cash. The cost of the option is only $160. If the stock doesn't do anything or goes down, you are only aout $160. But if the stock goes up, you will have the option of buying the stock for the lower amount and then reselling it for the higher amount with only having to put down $160.
This illustrates the leverage your money has with options investing. With little money you can make quite a bit of money.
Please keep in mind that options have a value associated to them based on how much they are worth if you did exercise them. There are two components that make up the value of an option.
- Intrinsic Value
This is the current value of the stock minus the strike price of the option. This represents how much you would make per share if you were to exercise you buy the shares at the strike price and sell them back onto the open market.
- Time Value
This gives value to how much time is left before the option expires. The more time left, the more time value there is, because there is more time left for the stock to make a significant price move.
Call Options
If you purchase a call option, you are guaranteeing you will be able to buy a stock from someone at a specified price between now and the end of the option contract.
Put Options
If you purchase put option, you are guaranteeing you will be able to sell a stock to someone at a specified price between now and the end of the option contract.
Insurance?
You can also think of options as a type of insurance on stock prices. You are paying a fee to have the option to buy and sell you stock at a specific price. If you are holding a volatile stock or you are uncertain of the future, you can purchase options to guarntee your price in the future.
The Downside
The negative point about options is that you are buying something that isn't worth anything, really. You don't own the stock, you just own a time sensitive contract between someone else and yourself. If the stock price moves significantly higher (for a call) you will be in the money and the option will be worth something at that point, but before then it is nothing. Stocks rarely ever go to 0 and you can always hold on to them forever. They actually mean something tangible.
When Would I Want to Buy an Option?
There are lot of scenarios and some of them are very complex. There is also the topic of "selling" options. I will cover this more later and you can read about it in my article Making Money Writing Covered Calls. The scenarios I have seen for buying options are:
- You believe that the stock in a specific company is going to go up significantly, but you are lacking the funds or margin to buy the stock outright for yourself and you want to buy quite a bit of it. For a smaller price you can purchase call options. If the stock goes up, you can purchase the stock later for the more favorable price or you can even just sell the option contract because its value will go up.
- You currently own a ton of stock in a company. You are scared to hold onto the stock because it has become extremely volatile or bad news has come out, yet the price is still quite reasonable. You don't want to sell right now because it is the end of the tax year or you want to wait a few months for other reasons. You can buy enough puts to match the amount of stock you have. If the stock goes down significantly, it won't be a big deal, because you have locked in a price to sell it at.
- You think a stock will go up in the short term and you don't want to own the stock because you can buy 10 times more options with the same amount of money and have more leverage. You purchase call options
- You think a stock will go down in the short term and you don't own any anyways. You can buy put options which will go up in value if the stock price decreases significantly.
Another item to look at is technical investing. This is a huge strategy used by options investors. You can read volumes on these strategies so I won't even go near them right now.
Look for more options strategies in my blog in the future.
If you enjoyed this post, then make sure you subscribe to my RSS feed or subscribe for email updates. Only one email a day and only if there was a new post.
Related Posts
Making Money On Covered Calls
Exercise and Procrastination
Finding a Hotel in Montreal
Montreal Aiport - Photo Of The Day
Montreal Tulips - Photo Of The Day
Category: Investing
0 Comments
No approved comments yet.