ABCs of Options: What Novice Investors Should Know
The subject of options in investment is a broad one and can appear overwhelming to new investors. Options continue to be a hot topic in the news as investors in platforms like Robinhood drive interest. But how options work is quite simple if you know the basics. Options are merely another asset class that investors can have in their portfolio, in addition to stocks, bonds, ETFs, etc.
Options are contracts that give the bearer the right but not the obligation to buy or sell some underlying asset at a predetermined price. The option to buy or sell can be executed at or before the termination of the contract.
Options are a derivative product because their value is determined by the value of an underlying asset. Their nature allows investors to both speculate on and to hedge against the volatility of that underlying asset.
For example, an investor could sign an options contract to buy 100 shares in a Venezuelan rice-producing company called ABC. The shares of ABC are currently selling at $1 a share. The investor’s options contract gives him the right to buy the shares at $1 for a period of 12 months. The investor predicts that the turmoil in Venezuela will soon end, therefore increasing the price of ABC’s stock. If the investor’s prediction is correct, and the shares go up to $2 in the next 12 months, the investor can then get $2-shares for the price of $1.
Similarly, the investor could sign an options contract to sell 100 shares at a higher price if he expects them to devalue sometime in the future.
A call option gives the bearer the right, but not the obligation, to buy an underlying asset, such as a stock, commodity, bond, or any other asset class, at a predetermined price.
In the examples above, the option to buy 100 shares in the Venezuelan rice company stock is a call option.
A put option is a contract that gives the right, but not the obligation, to sell an underlying asset such as a stock, commodity, etc, at a predetermined price.
If the investor above predicted that the Venezuelan rice company’s stock price was going to fall and they wanted to hedge against that, they would sign a put option contract.
Understanding Basic Options Terminology
Part of what makes options seem complicated is their many terms. Here are some simple definitions of the most important options terminology:
Strike price or Exercise Price: The strike price or exercise price is the price that is set in the options contract, for which the holder can buy or sell the underlying asset. In the first example above, the investor had the right to buy shares of ABC for $1. So $1 is the strike price or the exercise price.
In options contracts, the strike price is known at the time the contract is entered into.
Expiration or Time to Maturity: The length of time the options contract is valid for is called its expiration or time to maturity.
In the Money (ITM): In its simplest form, ITM indicates that an option’s call/put (buy/sell) price is favorable compared to the current market price for that underlying asset. For example, if a call option’s buying price is lower than the underlying share’s current market price, the contract is said to be In the Money. The same is true when a put option’s selling price is higher than the underlying share’s current market price.
ITM does not take into account any premiums or commissions fees that must be paid on the contract. The investor should consider these very carefully when signing an options contract.
Out of the Money (OTM): This is the opposite of In the Money. If a call option’s strike price is higher than the current market price, the option is said to be OTM. If a put option’s strike price is lower than the market price, it is also OTM.
Remember that premiums and commission fees are not included when determining if an options contract is ITM or OTM.
Implied Volatility (IV): Implied Volatility is a metric that represents the market’s view of how likely a security’s price is to change. Supply and demand, and time to maturity, are major factors when determining an option contract’s IV. Usually, the longer the time to maturity, the higher the Implied Volatility.
Premium: This is the amount of money that an options contract is sold for. The premium is collected by the seller (writer) of the contract. For options contracts that represent underlying shares, the premium is usually quoted on a per-share basis, for a minimum of 100 shares. Premiums are usually higher for contracts with longer times to maturity or higher implied volatility.
Options contracts can represent any underlying asset class such as bonds, stocks, ETFs, and commodities. But stocks are the most common.
The biggest risk is that the investor pays money and gets nothing in return. Every options contract contains a premium, and they often also require commissions payments to brokers. The premiums are higher for contracts with longer expiration dates and/or higher implied volatilities.
The timing of options contracts is also tricky. Investors must make short-term predictions on stocks and are forced to act on them at expiration. This is not necessarily the best strategy for investors looking to go long on a diversified portfolio.