Don't Be Afraid of Options - Part 1

Definition of a Derivative
You have all heard of them and you all know that they're the reason for the recent economic meltdown: derivatives!  But what exactly are derivatives?  You won't need to crack open your calculus book just yet...A derivative, as defined by investopedia.com is "A security whose price is dependent upon or derived from one or more underlying assets."  So, there is an underlying asset, perhaps a stock, an exchange traded fund (ETF), a commodity, or whatever...a derivative is simply a security (something you can buy/sell) and its price is dependent on the price of that particular underlying asset.  Options are one kind of derivative.


In this series, I would like to demystify options.  Many people believe that options are risky and should never be avoided at all costs, while others believe they are the road to riches.  The truth is that options give an investor added flexibility.  One can be very risky and aim for very lofty returns or one can be very safe and enjoy dividend like payments.  Both can be achieved through options.

There are 2 types of options: call option and put option.  By owning a call option, you have the right to buy the underlying asset at a certain price.  By owning a call option, you have the right to sell the underlying option at a certain price.  This price is called the strike price.  An option also has an expiry date, usually the 3rd Friday of a particular month.


An Example
There is no better way to explain how an option works than using an example.  Let's use Walmart (Ticker: WMT) as our underlying stock.  In the figure below, you will see a table of option prices for Walmart.  It is for the September 2010 contracts (i.e. the options expire on the third Friday of September 2010).  The top half of the table shows the prices of the call options and the bottom shows the prices of the put options.

Let's say we are bullish about Walmart and think the price will go up.  The Walmart stock is currently trading at $48.95.  We think it will go to $60 in September.  So, what we do is buy an option at the strike price of $55.  The asking price of the option is $0.10, and this is the price you will likely pay if you issue a market order.  Each contract will give you the right to buy 100 shares of WMT at $55 any time before the 3rd Friday of September 2010.  One thing to note is that the price shown here is on a "per share" basis, which means the actual contract will cost you $0.10 x 100 = $10.  Remember that you will need to pay commissions on this transaction, which may increase the cost significantly.


So, we bought our September contract for $10.  Sure enough, WMT rises to $60 in September.  At this point, what is the option worth?  Well, if you were to exercise the option (i.e. exercise your right of buying 100 shares of WMT at $55), you would have made $5 per share because WMT is worth $60 right now.  So, the option is likely to be worth at least $5/share or $5 x 100 = $500 for the contract.  At this point you have 2 options on your options (sorry, pun intended).  You can either exercise your option and pay $55/share to buy 100 shares of WMT (i.e. pay $5500 and possibly sell them right away for $6000 at market price) or you can sell your option for a little over $5/share.  Either case, you will make about the same amount.  Now, lets' see...we paid $10 for the contract, and it is now worth $500...WOW, 5000% gain in 2 months (before fees)!  Now, you see why people think you can make it big with options!


So, on the flip side, what happens if WMT rises, but only to $55, or worse, it drops?  If WMT, on the expiry date in September, trades at $55, your option is essentially worthless.  Think about it...if I can buy the WMT shares in the open market at $55, why would I need an option at $55?  Worse, if the shares trade at less than $55, then the option is really worthless, because why would I want the right to buy the shares at $55 when I can acquire them at cheaper prices?  The option is called "out-of-money" when this is the case.  (In the case above where WMT is at $60 and the strike price is below this current trading price, it is called "in-the-money")  So, in this out-of-money case, your option would expire worthless and you lose 100% of your investment.  Do note that at $55, the stock has risen more than 10% from when you first bought your option.  So, you were right about WMT, but just not right enough!  And you still lost 100% of your money.


Buying a put option is essentially the same as a call option.  If the price of the stock falls, your option will increase in value, similar to how the call option increases in value as the price of the stock rises.  The put option would be in-the-money if the stock price falls below the strike price.


As you can see, buying a call (or put) option alone gives you great leverage, but you could also lose your entire investment.  As such, I never encourage having a significant portion of your portfolio in options only.


Sounds Like I Should Be Afraid of Options!?!
Not so quick.  Options do have a huge advantage.  Let's go back to our successful example above.  By investing $10 + fees, your potential returns are limitless.  If WMT skyrockets because of fresh news or a blowout quarter, and the share price rises to $70 (you make $1500), you could have 15000% returns!  However, if you are wrong about your prediction, the worst that can happen is you lose 100% or $10 + fees.  Your downside is limited, but your upside is limitless!  (Actually, this is true for buying shares also, but with options, you are highly leveraged and your upside can be very high easily.)


This post is just a very brief introduction to how options work.  In the next post, I will talk about the factors affecting the price of an option.  As you can see in the table above, there are so many options you can buy on just 1 stock.  We shall explore which options to pick with different goals in mind.  Have a good weekend!