Options

As versatile investments, options can help meet many different objectives. By employing both fundamental and technical research, McGinnSmith develops options strategies to assist the more sophisticated investor in pursuing his or her individual investment goals.

Types of Options

Options and futures are both very complex investments. They are classified as derivatives, meaning they are derived from other investments. They are not backed by anything as stocks and bonds are (stocks represent ownership in the company, bonds are backed by a promise to repay). Instead, they are a bet on the future price of a security over a specific period of time. Futures contracts represent the obligation to buy or sell a specific quantity of a commodity on a certain day at a preset price.

For example, if you hold a contract to buy 5000 hog bellies and it comes due, you are obligated to buy the hog bellies. Options, on the other hand, are the right to buy or sell a specific security for a preset price during a specific period of time.

Futures and options are classified as speculative investments, but that doesn't mean that they have to be high risk. They can be used in many different ways, at various levels of risk. Some people speculate by trading in and out of the contracts, while others use them as protection against price swings in the underlying investments. Stories are told all the time about the ambitious trader who lost thousands gambling on options, but options and futures can also be a great risk management tool when used properly. Airline companies buy oil futures to protect against future price changes. By limiting their exposure to swings in oil prices, they can more accurately plan their cost and pricing structure. While futures are not an appropriate tool for most individual investors, options can be used to manage risk in equities.

For example, if an investor owns 1000 shares of a stock and wants to protect against a sharp drop, he may buy put options. Put options give him the right to sell the stock at a particular price for a given period of time. He will pay a fee for the options, which will decrease his return, but if the stock drops sharply he can avoid even bigger losses by exercising the options and selling the stock at a price higher than the market price.

Calls represent the option to purchase a security at a specific price (strike price) by a certain point in time. When purchasing an option, an investor's risk is limited to the premium (dollar amount) he pays for the option. When selling a call, the seller takes on the obligation to sell a specific amount of a security at a specific price if the option is exercised. This is also known as writing a call. In exchange for taking on this obligation, the investor receives a premium from the buyer of the option. If an investor sells calls and does not own the underlying security, he takes on a significant amount of risk since in theory his maximum loss is unlimited. The maximum profit when selling calls is the amount of the premium.

Puts represent the option to sell a security at a specific price at a certain point in time. Again, when purchasing a put option, the investor's risk is limited to the premium he pays for the option. Selling a put is taking on the obligation to purchase a specific amount of a security at a specific price if the option is exercised. This is also known as writing a put. The maximum profit in this situation is the amount of the premium. When selling puts, an investor is taking on a significant amount of risk, especially if he does not have the money to purchase the security.

Intrinsic and Time Value

Options have both intrinsic value and time value. Intrinsic value represents the actual difference between the option's strike price and the market price of the underlying security. If an option has a $50 strike price and the stock is selling at $55, the option has $5 of intrinsic value. A holder could exercise the option, purchasing 100 shares of the stock for $50 each. He could then immediately sell the stock in the open market for $55, making a profit of $5 per share. Options also have time value. An option that has a longer period of time until expiration will have more time value than one with a shorter time until expiration. Using the example above, a three month option may have a time value of $1, bringing the total cost of the option to $6, while a 9 month option may have a time value of $3, bringing the total cost to $8. Time value also depends on the volatility of the underlying security and investors' expectations of future price movements.

Leverage

Options and futures are known as leveraged investments. This basically means that the effect of price changes in the underlying security is magnified. If a $50 stock quickly rises 5 points, stockholders make 10%. But since options on that stock trade for much less than the price, options holders may make 100%, or even more. A short-term call option to purchase the stock at $50 is likely to be trading for $2-3 before the price jump, when the stock is at $50. When the stock moves to $55, the option now has $5 of intrinsic value. So it is likely to move up to $7-8, giving investors a 200-300% profit.

Reducing your risk

Options may be effective at reducing risk in your investment portfolio, since they can act as insurance policies against a drop in stock prices or produce income through strategies that limit the maximum loss to which you’re exposed.Options can be used to hedge, or protect against losses in another investment. For example, you might hedge against a drop in the price of a stock you own by purchasing a put on that stock. In return for the premium you pay, you’ll have the right to sell the shares at a price that’s acceptable to you, locking in unrealized profits or preventing losses below the strike price. In that case, your option works like an insurance policy, protecting you against loss.