Options Trading - What are they, why are they useful?

I’ve been experimenting with options as a way to turbo charge my portfolio for the past year or so. Overall, I’d say my trades so far have been a wash, but I still think it is a very valuable strategy to heavily leverage your portfolio and limit your risk. In discussing options trades with friends, I’ve realized most people I talk to know nothing about options. They may have some stock options though work, but buying and selling options in a regular brokerage account is a whole different ball game. For the next few weeks, I’ll be posting a series of articles designed to give the average person an introduction to options trading, and I’ll try to sprinkle in some of my own experiences along the way.

The first topic will be a basic introduction to options. What they are, how they are useful to you, what the risks are and what the potential rewards are. Check back every few days for new postings to get you acquainted with options trading and learn about how options trading strategies can be a good way to complement your existing portfolio.

Options Trading - The basics

Trading shares of stock has become as common as surfing the Internet. But, like any financial investment, trading stock is risky. The price can fall unexpectedly and stay down for lengthy periods. Many investors have a hard time liquidating a losing position, constantly waiting for the stock price to rebound. There is no forced exit point and no clean break from your underwater position. To force an exit point to losing positions and to heavily leverage your investment in a given security options are… well, an option.

An option is a contract giving the investor the right to buy or sell a security at a given price on or before a stated date. The last portion is crucial… on or before a stated date. European options are similar to American options, except American options let you sell any time leading up to the expiration date which, I view, is a huge and critical advantage.
Options contracts are written on all sorts of underlying assets: real estate, stocks, bonds, etc.
The basic idea is simple. Invest a fairly small sum today to control something worth a often much larger amount. Depending on your strategy, you can bet that the price will move up, down or within a range before a certain date, then you can sell (or close) your position and pocket the difference.

For example, suppose Google shares are selling at $500 per share, but buying 1,000 shares of GOOG at $500 each would cost $500,000. I don’t know about you, but I don’t have half a million to invest in one company, thats putting a few too many eggs in one basket and is far beyond the means of the average speculator.
You could buy on margin, but you’d still likely have to put up half of that money in cash and would be liable for the other half should the stock go down (not something I’d be looking forward to). The other option in this scenario gives you the option to control that 1000 shares of Google stock without having to come up with all the money up front. Simply buy an option at, say, $30 per share (the ‘premium’). Now your investment is $30,000 - hefty, but within reach. That’s called ‘leverage’, and it can be your best friend when you are trying to turbo charge your portfolio.

Each option has an expiration date - the date at which the investor must “exercise his option”, i.e. make a decision to buy/sell the underlying security or lose his invested money. Depending on the underlying asset, and other factors, the date can be anywhere from a day to several months in the future. LEAPs even allow you to buy options on a given security for years in the future.
Options also have a strike price - the price at which the underlying instrument has to be bought or sold when exercising the option.

Continuing the example, suppose the option for GOOG expires in 30 days and has a strike price of $510. The break-even price would be $510 + $30 = $540 per share. At this point, you are ‘under water’ by $40 per share x 1,000 shares = $40,000. You put $30,000 into the transaction and the stock needs to go up by $40 just for you to break even Doesn’t sound so exciting so far does it?
But, lets assume three weeks pass and Google announces some good news about earnings. The price per share rises to $540. Now you can exercise your option by “closing out your position” and selling your contract to buy the underlying stock.

The options contract price has increased as well, to $35. Your profit is: ($35-$30) x 1,000 = $5,000. (Ignoring likely $25 in brokage fees.) Not bad. Five thousand dollars on a $30,000 investment is about a That’s a 16% profit on a $30,000 investment. If the price of Google had fallen over the same period, your $30,000 investment would be completely at risk, thats where risk and hedging strategies come in which I’ll talk about in a future post.

Buying and risking $30,000 on a single security is still more risk than I’m willing to take, so most of my options positions are in the $800-$1500 range. Commissions eat up more of the profits as a percentage, but the way options move, typically $25 in brokerage fees becomes fairly insignificant by the time I’ve executed my options trade.

Options aren’t for everyone. They’re more complicated (though not too much), riskier, and generally involve shorter term trades and the requirement to watch the market more closely.

But note that purchasing the options contract did NOT involve investing 6% ($30/$500 x 100%) and borrowing the other 94%. Options contracts are a straight investment of funds, not a broker loan.

If the price goes in the predicted direction before expiration, you make money. If the price goes the other way, you lose (some or all of) your investment. The contained risk is an aspect I appreciate and the forced exit is also a benefit. If you buy an option 60 days in the future, whether the stock goes up or down, you will exit that position in at least the next 60 days, guaranteed. You may be up, you may be down, but you’ll be out. That forced execution is better in risk planning, liquidity strategies, and a general training tool to force yourself to be disciplined in your other investment decisions. I know I’m not the only one who has bought a long stock position that declined below my purchase price, then I held onto it through future declines in a hope that it would increase over time to recover my investment. Options force you to close things out in a predetermined time period. Your ability and skill at predicting short term price movements becomes more critical, but you’ll never be caught holding a dog for years, tying up your investment capital and eating away at your confidence every time you look at your list of open positions.
As with any investment, do your homework. Make sure you understand how options work and what the relative risks are. In particular, study the market for that type of underlying instrument. Throwing darts blindly is the least successful options trading strategy.