Using Options to Reduce the Risk of Fluctuating Stocks
This is a guest post by personal finance blogger, John @ Fearless Dollar. If you’re interested in guest posting please contact us.
If you own or have followed stocks, you know that they can fluctuate wildly in price. There’s another game within the stock market known as options. This is a market all to itself which mimics the movement of stocks.
It’s not advisable for the inexperienced to play the option game itself, and this is why you’ll often see this disclaimer.
“Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital”
I’m only now learning about options but I do have 9 years of experience trading stocks. Before dabbling in that I leanred the foundation, lingo and risks. It’s impotant to do the same with options.
How Do Options Work?
The stock market is totally money driven. The stock you own has good news but the price doesn’t move – nobody cares, or better yet the price goes down – why? The money sold your stock on good news, confused? Welcome to the world of stocks.
Now, options are called “contracts.” Each contract has strictly defined terms. One contract equals the rights to control 100 shares of the stock that option is associated with. The key word is “controls” not own. Consider options like a lease with the option to buy.
Here is a perfect example from Investopedia
The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you’d love to purchase. Unfortunately, you won’t have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
- It’s discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million – $200,000 – $3,000).
- While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.
Two Types of Options: Calls and Puts
- A call – The holder receives the right to buy an asset as a specific price within the specified time period. If you buy a call it is because you’re hoping the stock will increase before your option expires. A call is similar to holding a stock long term.
- A put – The holder receives the right to sell this asset at a specific price within the specified time period. If you buy a put it is because you’re hoping the stock will fall before your option expires. A put is similar to holding a stock short term.
You have 100 shares of IBM. The price is at $80.00 a share, you don’t want to sell the stock, but you have a feeling the next few months might be rough. In this case you can buy one put contract. A put contract protects a stock from going down.
How it works. IBM is at $80.00, you buy one put at a price of $75.00 for a term of four months. The price of that put is $5.00, that’s $5.00 x 100 shares (remember 1 contract equals 100 shares), so the price for this type of protection is $500.00. If within that four month time frame IBM goes down to $60.00 a share, you have covered the majority of the loss, $15.00 (the difference between your contract price of $75.00 and current price $60.00). If you were to exercise your option that day, you would make $1500.00 minus fees, and you still own the IBM stock.
What if you do nothing after four months? Remember, options are a lease against a real stocks. If you do nothing after four months your option expires, it’s dead. You paid $500.00 for insurance, for a specific time frame. If on the day your option expires IBM is still at $60.00, you reduced your loss significantly.
Here are two things to remember. You have the right to exercise your option at any time between the purchase date and expiration date. You can also sell your stock at any time and still own the options until expiration date.
This is the most basic of options for reducing risk against stocks.
Who Plays in the Options Market?
There are four types of players depending on the position they take:
- Buyers of calls
- Sellers of calls
- Buyers of puts
- Sellers of puts
If you buy an option you’re called a holder and if you sell an option you’re called a writer.
Key Differences between buyers (holders) and sellers (writers):
- If you are a buyer of a call or a put you’re not obligated to buy or sell. You have the choice to exercise your option (contract) rights if you choose.
- But if you’re a seller, call writer or put writer, you are obligated to buy or sell. This means that you (the seller) may be required to fulfill your promise to buy or sell.
It’s important to remember that being a seller is far riskier and involves a lot of rules you definitely want to know before venturing into this part of options.
The Lingo You Should Know
Strike Price – The price at which an underlying stock can be purchased or sold
In-the-money – For calls, if the share price is above the strike price. For puts, when the share price is below the strike price.
Premium – The total cost (the price) of an option
Featured image by http://dribbble.com/style.css