What do you first think of when you think of stock options? You might think they belong to those lucky few that have a company go public via an Initial Public Offering (IPO). Perhaps you thought that only the well off in established companies get the benefit. Both are partly true but not fully. In fact, public stock options are accessible to almost anyone, if you have enough experience and enough assets.
Investopedia defines a stock option as the following:
KEY TAKEAWAYS
Options give a trader the right to buy or sell a stock at an agreed-upon price and date.
There are two types of options: Calls and Puts.
One contract represents 100 shares of the underlying stock.
– Investopedia
In our last piece on baby bonds, we mentioned how we can increase our returns and reduce our risk. We saw the difference a sustained 2% extra every year for 60 years can do for our returns. In this series, we will be sharing the lessons we have learned with stock options, and walk you through, how to get started. By the end of the series, we’ll explain our strategy for increasing returns and reducing risk using stock options as the main pillar. Keeping in mind our focus on ESG companies, we can use stock options to take part in the coming ESG transformation.
Options have their own language
Options have their own language. When you are learning a new language, there will be a learning curve. You have to use the language, immerse yourself in it, to get the full benefit. In Part 1, we’ll introduce the basic language of options.
Calls and Puts
There are two main flavors of options, calls and puts. Calls allow you to participate in the upside of a stock going up without actually owning the stock. Puts are the opposite. Puts allow you to participate in the stock going down without actually having a position in the stock.
Buying and Selling Calls
Let’s step back a moment. When you buy something from a retail shop, let’s say a tee shirt, someone is on the opposite end of the transaction. That’s obvious, you are the buyer and the retail shop is the seller. If you were to return the tee shirt, you become the seller and the retail shop becomes the buyer. The same concept applies to buying and selling calls. Each call represents buying 100 shares of the stock. This is called a call contract.
Every time someone buys a call, there is a seller on the other side. At any time, you can choose to be the buyer of the call or the seller of the call. You can imagine that selling the call has more risk, and financial institutions will have higher requirements to set aside money for selling a call than buying a call. People buying calls make money if the stock price is higher than the contract price, and people selling calls make money if the stock price is lower than the contract price.
Buying and Selling Puts
Puts are not as obvious to understand. Once you get the hang of them, they are the same difficulty as calls. Our day to day experience as consumers doesn’t have many examples of a put. We’ll use the example of our shop. Our retail shop wants to buy 100 tee shirts from a wholesaler. Each tee shirt is $15. The retail shop is concerned the price of cotton may drop over the next three months. If the price of the cotton drops, the tee shirt will only be worth $12. That means the retail shop could lose $300 if the price of cotton goes down, an unacceptable level of loss. They would buy the tee shirts for $1500 and only be able to sell them for $1200.
The wholesaler offers the retail shop a way to offset the loss. The wholesaler will charge the retail shop $0.50 for each tee shirt. If the price of the tee shirt goes down from $15 to $12 over the next three months, the wholesaler will offer to buy each tee shirt back at $15. The retail shop thinks this is a good way to reduce risk, with an acceptable level of loss. The total loss now is $0.50 * 100, which gives us a $50 loss. That’s much better than the $300 loss from before.
In our example, the wholesaler is selling a put, and the retail shop is buying a put. The retail shop is buying the put contract on tee shirts at $15, for a time period of 3 months. The wholesaler is getting $50 up front, selling the put contract on tee shirts at $15, for a time period of 3 months. The $50 received is called the contract premium or option premium. $15 would be the contract price. The retail shop will profit if the price of tee shirts goes down below $15, and the wholesaler will profit if the price of the tee shirts stays the same or increases. Both decide the risks are acceptable and enter into the put contract.
All options are time based
All stock options have a definite date where the contract is no longer valid. When the contract is no longer valid, the option has expired. There are all kind of time frames involved. There are weekly options, expiring every Friday. For monthly stock options in the US, it is the third Friday of every month. Any time frame beyond a year is called a LEAPS option (which stands for Long-term Equity Anticipation Securities). Unless a stock goes bankrupt, bought out, or gets removed from an exchange, stocks do not expire. To buy an option and profit, you must be right on the direction and timing of the stock. That is not an easy task.
All options involve a bid price, an ask price, and a spread
Every call option and put option has two prices. One is the bid price. This is how much someone is willing to pay to buy the option. The second is the ask price, which is how much someone wants to sell the option. The difference of the ask price minus the bid price is called the spread. The larger the spread, the less number of buyers and sellers that are fighting to buy and sell the option. The larger the spread, the higher the risk.
Please remember, anything here is not investment advice, and is for educational purposes only. We are not investment professionals providing investment advice. Options are like surfing: you can ride the big wave or you can crash and burn. Our hope at smilingdad is this article provides you an easy guide on understanding options and has helped demystify the language of options.
Here’s a downloadable spreadsheet on the examples I gave above.
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Warmest regards,
smilingdad
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