What are Options?
The main question new investors ask these days is: What are Options?
In a nutshell, they're 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.
How do you get even more leverage?
Options offer leverage that can turn a $1 investment into $3, $4, $10, or even more! And that's why the smartest investors in the world gravitate to the product.
Options are governed by a contractual agreement between two parties dictated by several important points. The main ones are the:
- Stock Price: The underlying asset represented by the option.
- Class: Whether Calls or Puts.
- 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 contract expires at the close of market hours.
- Premium: The cost to the option buyer on a per-share basis.
- Multiplier: The amount of shares represented by one contract.
Example: 100 shares
Option Buyer vs Seller
Options contracts can be bought or sold by the user. From the start, I want to make the following distinction very clear:
- Option buyers are buying leverage
- Option sellers are selling leverage.
This leads us to one of option's most unique characteristics.
The Option Buyer is purchasing a financial product with limited liability and unlimited gain. This means that the buyer can only lose the upfront premium paid.
Sellers, on the other hand, get the benefit of receiving the upfront premium, but inherit the risk of 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.
Options trade on various government-regulated exchanges and cleared through the Options Clearing Corp (OCC). The OCC stands in the middle of each trade and acts as the counterparty to both buyer and seller. So, while you're buying or selling an option against another person or institution, your counterparty is the OCC.
Like stocks, Options contracts are securities that can be bought or sold on the exchanges during open market hours for the life of the contract. Investors do not have to wait until the contracts expire in order to exit the position.
Finally, while Options give you exposure to the price movements of the stock, you do not receive any dividends paid out by the company. You only receive a dividend from the company when you own the actual stock.