Investors use options because they are the most important financial tool of our generation. For this reason, every investor, active or passive, should have a clear understanding of the product.
Let’s break options down into 3 further questions:
- What are they?
- Who uses them?
- How do they profit from them?
What are Options?
In a nutshell, an option is a tool that provides financial leverage. Leverage allows an investor to participate in an investment without having to put down the total cost of that investment.
For example, let’s assume you wanted to buy a stock that costs $100. With a brokerage margin account, you could buy that stock by only putting up $50. The broker will lend you the other $50. Buying 1 share of stock that cost $100 with only $50 of capital is called leverage.
Options offer much more leverage than trading stock. They offer this leverage through a contract using important terminology:
- Stock Price: The underlying asset represented by the option.
- Strike Price: The Price where the exchange of stock happens at the expiration date given certain stipulations in the contract referring to where the Stock Price is relative to the Strike Price.
- Expiration Date: The date that the option contract expires at the close of market hours.
- Premium: The cost to the buyer of the Options on a per-share basis.
- Multiplier: The amount of shares represented by one options contract.
Buyer or Seller
These contracts can be bought or sold. So, as it pertains to leverage, it becomes important to make the distinction whether you are the buyer or seller. The buyers of the contract are buying leverage. The sellers of the contract are selling leverage.
This leads to an option’s most unique characteristic. The buyer purchases a financial product with limited liability and unlimited gain. More specifically, the buyer can only lose the cost of the option.
On the other hand, sellers get the benefit of receiving the upfront payment. This comes at the cost of greater risk, specifically to unlimited losses.
While both buying and selling options contracts can be profitable, it’s necessary to understand both styles and then match your goals and investment personality to the one that fits.
Finally, options contracts are securities and trade on the various market exchanges regulated by the government. Like stocks, these contracts can be bought and sold on the exchanges during the life of the contract. One does not have to wait until the they expire in order to get out of the position.