How Options Work: A Basic Guide
Most people are relatively familiar with basic financial instruments like stocks and bonds. While these are the most accessible products, they are not the only option available to investors who are looking to make outsized returns.
There is a whole other class of investment products, called derivatives, that are available to you to grow your wealth. Derivatives are financial products whose price is derived from the price of another underlying financial instrument, such as a stock or bond. Derivatives are usually considered to be leveraged instruments. This means that you only need a small amount of capital to have a large exposure to the underlying asset.
The potential upside when trading derivatives is much greater than when trading stocks and bonds. That being said, investors who choose to invest via derivatives are advised to do so with caution as greater potential rewards also come with greater potential losses.
Options are one type of derivative and are the most commonly traded derivative among retail investors. Below, we have prepared a simple explanation of the different types of options and how they can be used by savvy investors.
Table of Contents
Option Basics
An options contract gives investors the option, but not the obligation, to buy or sell an asset at a predetermined price and date. An option that gives an investor the right to buy an asset is known as a call option, whereas an option that gives an investor the right to sell an asset is known as a put option.
Basic Options Terminology
- Premium: The price that you must pay to acquire the option itself and is on a per-share basis
- Exercise or Strike Price: The price the option holder will pay/receive for the underlying asset if they decide to exercise their right to buy/sell it
- Expiration Date: The last day on which you can exercise your option to buy/sell the underlying asset
Options Investing Jargon
Other terms that you will frequently hear when discussing options are in the money, out of the money and at the money. Options are said to be in the money when they have a positive payoff for the holder, meaning that the value of the option is greater than $0, and out of the money when they have a negative payoff.
When an option produces a $0 payoff, it is said to be at the money. In this instance, investors are indifferent as to whether they should exercise their options contract.
Two other terms you’ll hear when discussing options and stocks are long and short. When you buy a security, you are said to be long; selling a security would mean that you are short that security.
Lastly, options usually come in two varieties: American and European options. American options allow the holder to exercise the option on or before the expiration date, while European options only allow the holder to exercise the option on the expiration date.
Typically, an investor has to buy options contracts in lots of 100 shares of the underlying stock. In our examples below, for simplicity's sake, we shall assume that we are trading an option for one share of the underlying stock.
Call Options
As mentioned above, a call option gives its holder the right, but not the obligation, to buy a financial asset at a predetermined price by a predetermined date. Investors can both buy and sell (or “write”) an call option.
Buying a Call Option
Let’s illustrate the mechanics of buying call options with an example. An investor buys a call option for Company A. The strike price is S$60, the premium is S$10 and the expiration date is one month from today.
Soon after buying the option, Company A’s stock rises to S$75 and the investor decides to exercise the option. Since the call option is “in the money,” the investor can now pay S$60 to buy a stock that is worth S$75, earning a profit of S$15. After subtracting the premium the investor had to initially pay (S$10), their total profit comes out to S$5.
What if the stock declines in value? If Company A’s stock declines to S$50 per share, the investor would not choose to exercise the call option because it is “out of the money.” After all, you won’t want to spend S$60 to buy something that you can get for S$50. In this case, the investor would have lost the S$10 that they initially paid in premium.
Our graph below demonstrates the payoff of this call option depending on how the stock price behaves.
Selling or Writing a Call Option
You can also sell (or write) a call option. In doing so, you are essentially selling someone the right to buy a certain stock at a certain price. For instance, you could write a call option for Company A, with an exercise price of S$60, a premium of S$10 and an expiration date one month from now.
On the expiration date, if Company A’s stock has declined to S$45 per share, the buyer will not exercise the option since the option is out of the money. You, the seller, consequentially will make a profit of S$10 from the premium you charged when selling the call option.
It is important to note that as a writer of a call option, you have an unlimited downside if the stock increases in value.
If Company A’s stock goes up to S$80 per share, the call option will be in the money. If your buyer chooses to exercise the option, as the seller of the options contract you are obligated to sell the stock to the buyer at the strike price. (Note the difference from buyers of options who have the right but not the obligation to buy the underlying asset.) This means that you will have to buy the stock for S$80 and sell it for S$60 to the buyer, which nets you S$10 of loss, after accounting for the S$10 you make from the options premium.
This loss can increase infinitely if the stock price continues to increase. In the graph below, we can see that the call option writer turns a profit only when the stock price is below the exercise price plus the premium charged (S$70 in this case).
Put Options
A put option gives its holder the right, but not the obligation, to sell an underlying asset at a predetermined price and date. Like a call option, an investor can either buy or sell (write) a put option.
Buying a Put Option
Consider an example where you are buying a put option for Company B with an exercise price of S$45, a premium of S$15 and an expiration date one month away.
Company B stock drops to S$25 a share the following week. In this case, exercising your option will yield a profit of S$5 because you can buy a stock for S$25 and use your option to sell it at S$45 (S45-S$25-S$15=S$5).
If the price of the stock increased instead, then it wouldn’t make sense to exercise the option. For instance, if the stock price increased to $55, then you wouldn’t want to sell the stock for $45. In this situation, your loss is limited at S$15.
Selling or Writing a Put Option
Just like a call option, you can also sell (or write) a put option.
Let’s assume you sell a put option for Company B for a premium of S$15, a strike price of S$45 and an expiration in one month. If the price of the stock increases to $50, you will generate a profit on the put option. The buyer will not choose to exercise the option and sell the underlying asset since the option is out of the money. You get to profit the S$15 premium.
If the price of the stock declines, however, your potential loss can be very large. Let’s say the underlying stock declines to S$30 per share. Since this is S$15 below the exercise price, you would lose a total of S$15 minus the S$15 premium, which nets out to S$0. If the stock price fell even further, you would be in the red as the premium would not be enough to offset the difference between the stock price and the exercise price.
A key difference between selling put options and selling call options is that the downside to selling a put option is not limitless, unlike selling a call option. While the price of a stock could hypothetically increase infinitely, the price of a stock can at the very most decrease to zero. Thus, as a seller of a put option, you are able to anticipate your maximum potential losses (zero - exercise price + premium).
How to Buy Options
When buying an option, an investor will have to consider a few factors, including:
- the duration of the option,
- the premium of the option how and
- the underlying stock price will behave.
Below is a simplified version of how options contracts normally appear.
Generally, the longer the maturity of an option, the higher the premium. This is because with a longer duration until the options expiration date, there is greater uncertainty about how the price of the underlying asset can change. This translates to greater risk for the seller of the options contract. As such, the writer of option would demand a higher premium to take on that risk. It’s much easier for a stock to move from S$100 to S$500 over 5 years than in 10 days.
The price gap between the strike price and current stock price will also impact the premium. If, for example, you want to buy a call option for a stock that is currently at S$50, it will be more expensive to buy an option with a strike price of S$51 than to buy an option with a strike price of S$60.
As a buyer of an options contract, you can calculate your profits, barring any broker’s fees, as follows:
- Call options: Profit = Price of Underlying Asset – Exercise Price – Option Premium
- Put options: Profit = Exercise Price – Price of Underlying Asset – Option Premium
What Are The Benefits of Options Trading
It is important to have a clear understanding of how options can add to your investment plan before trading them.
One of the main reasons investors use options is to manage risk. Owning an option of a stock and owning the underlying stock itself have very different risks and returns. Buying a call option gives the buyer greater upside while simultaneously limiting the downside as compared to buying the underlying stock. At the same time, if the stock goes down, you will limit your loses to only the premium you paid to buy the options contract.
Lets illustrate this with an example. Assume a stock has a price of S$40 and you can buy a call option for the underlying stock with a strick price of S$45 for a premium of S$5. If the stock declines to S$20, the stockholder will lose S$20 on a S$40 investment (-50%), while an option trader will only lose the S$5 premium they initially paid for the call option (-100% of initial investment).
On the other hand, if the stock rises to S$60, the stockholder would have made S$20 on a $40 investment (+50%), while the call option holder would have earned S$15 ($20 price increase - $5 premium) on their S$5 of investment (+300%).
However, your loss when trading options is also definite unless the stock moves in your desired direction before the options expiration date. When you own the underlying stock you have the luxury of waiting indefinitely for the price of the stock recover.
It is important to find a trading platform that suits your preferences and needs when trading these more complex derivative instruments. If you are interested in getting started in options trading, check out our comparison of the best online brokerages available in Singapore.
