Options for the Meek
Are you a low-risk investor? Does the idea of taking your money out of your mattress terrify you? Is a mutual fund your idea of a high-risk investment? If so, then stop reading right now. This article is not for you. This article is about something that makes even the savviest Wall Street wizard break out in cold sweats. Yes, that’s right, I’m talking about options.
Before we go any further, let me just reiterate my warning about options. Options are not for everyone. They are complex and highly leveraged financial instruments that can be devastating in the wrong hands. Most of the headline-making financial disasters of the last quarter-century have involved options in one way or another. The collapse of Barings, the meltdown of Orange County and the unraveling of Long Term Capital can all be pinned squarely on options. Some people even blame the crash of ‘87 on the “shadowy” option markets. This article is a basic introduction to the world of option trading. The following paragraphs contain the financial equivalent of NC-17 material. Read them at your own risk.
THE DRY STUFF
The technical definition of an option is the right to buy or sell a specified security at a specified price by a specified date. In options parlance,the specified price is known as the “strike price” and the specified data is known as the “expiration date.” There are two basic types of options: calls and puts. Calls give you the right to buy a security at the strike price while puts give you the right to sell it at the strike price. How can trading the rights to buy or sell something be so profitable, and so dangerous? The answer is leverage. Options allow you to put on large positions at a fraction of their normal cost. Let’s say that you are interested in buying 1000 shares of XYZ corporation. However, XYZ corporation is currently trading at $100 a share. This means that you would have to pony up a cool $100,000 to buy the stock. That high price tag puts the trade out of the reach of most investors. However, there are alternatives to buying the stock. Through the magical leverage of options, you could create a synthetic position that is equivalent to owning 1000 shares of XYZ stock. The best part is that it would only cost a fraction of purchasing the stock outright.
Here’s where it gets a little confusing, so try to stay with me. Instead of buying 1000 shares of XYZ stock, you decide to buy XYZ call options. Because call options give you the right to purchase the stock, they gain in value when the stock price increases. You decide to purchase “at-the-money” call options, or options that give you the right to buy the stock at its current trading price of $100. Since you believe that XYZ stock will increase in value quickly, you decide to purchase “front month” options, or options that expire at the end of the current trading month. Since the options that you are purchasing expire in a short period of time, and because they only allow you to purchase the stock at the same price that you can purchase it in the open market, they are not worth very much. Their only value comes from interest and volatility.
If you’re confused then don’t worry, so are the vast majority of financial professionals. Most people have a hard time wrapping their heads around the synthetic nature of options. Options, unlike stocks and bonds, are not tangible investments. When you buy a stock, you own a tangible piece of a company. When you buy a bond, you loan money to a company that promises to pay you back with interest. However, when you buy an option, you own an ethereal “right” to make a future trade. This lack of substance leaves many investors wary and more than a little skeptical. They become even more confused when they try to figure out option prices. Most companies have one common stock that trades at one easily identifiable price. However, a single company can have thousands of different options that trade at thousands of different prices. Adding to their confusion is the fact that option prices are “derived” from the values of their underlying assets. This is why options are called derivatives. Options on a particular stock are derived from the price of that stock. Options on a bond are derived from the price of that bond, etc. In order to accurately price an option, you must know exactly where the underlying asset is trading. Compound this already intricate scenario with additional factors like volatility and interest, and you have one thoroughly confused investing public.
Before we continue, go back and read the technical definition of an option again. Did you notice the term “specified date” at the end of that definition? That term reveals one of the primary reasons why options are so difficult to trade. Unlike stocks or mutual funds, options come with an expiration date. If your trade hasn’t become profitable by the expiration date, your options will expire worthless and your investment will be lost. That notion is a difficult one for most investors to swallow. We have become accustomed to “buying and holding” in our portfolios, riding out our losses until they swing back into winning territory. However, you cannot simply “buy and hold” in the options market. You must have a clear strategy that you expect to pay off within a specified amount of time. That extra level of difficulty is what keeps most amateur investors away from options.
With a solid knowledge of options, you can open the door to a world of trading strategies and techniques that you never dreamed were possible. Just remember, you’ve been warned…
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