Options

What are Options?

To own an option on a stock means that you have a right, but not an obligation to buy or sell the stock at a particular price. For example, if you own an option to buy a share of Microsoft at $100, then no matter what the current market price of the stock is, you can buy at at $100.

Types of Options:

There are two types of options: call options and put options. Call options are options to buy a stock at a certain price. Put options are options to sell the stock at a certain price. That’s all there is to it. These names don’t mean anything other than buy or sell.

Why are Options Valuable?

Options give you time to gather more information before you act. You can buy an option on a stock and then watch for any major developments. If there is any good news, the stock price would go up, and you would exercise the option (use it) to buy the stock. If there is bad news instead of good news, the stock price would go down and you would throw away the option, not buying the stock. Discovering new information is valuable to investors, and for this reason options are valuable. For example, you are more likely to make a better decision as to whether to bet on a baseball game, if you know what the score is after the 7th inning.

What are options used for?

There are two types of options: covered and naked options. Options are considered uncovered, or naked, when you own the options without owning the asset (in this case the stock). Options are covered when you own the asset for which you own the options. Each type of options is used for different things, as described below.

Naked options: naked options are most often used for gambling. You buy naked options based on the idea that you know/anticipate something regarding to the stock you are buying the options for. For example, consider this scenario:

  1. You think that Microsoft (it’s always Microsoft, isn’t it) will make some dramatic announcement that will send its stock price up $10/share.
  2. You buy 100 call options to buy MSFT at the current price of $81/share for (let’s say) $3 per option today.
  3. Next day, MSFT makes the big announcement.
  4. It’s stock goes up to $91/share.
  5. You exercise your options and buy 100 shares of MSFT at $81/share.
  6. Two seconds later, you sell the 100 shares at $91/share.
  7. You just made ($10 - $3 =) $7/share ($700) on an investment of $300 ($3/option) in 1 day.
  8. That’s a return of over 200% in 1 day  some massive APR.

Now let’s consider another scenario:

  1. You think that Microsoft (it’s always Microsoft, isn’t it) will make some dramatic announcement that will send its stock price up $10/share.
  2. You buy 100 call options to buy MSFT at the current price of $81/share for (let’s say) $3 per option today.
  3. Next day, MSFT does not announce anything.
  4. 29 days later, MSFT still hasn’t made any announcement and the stock has done almost nothing, trading now at $79/share.
  5. Your options expire tomorrow.
  6. If you exercise them, you’ll lose $5/share ($81-$79 and $3/share initial investment).
  7. If you keep them, tomorrow they will be worth the paper they are written on (nothing)
  8. Alternative 7 is less of a loss than 6, so you’ve lost all of your $300 investment.
  9. That’s a return of –100% on your investment in 30 days  fairly massive negative APR.

The point here is: naked options are very risky. You can make a lot of money, but you can usually lose just as much. Unless you have inside information, it’s usually not a good idea to buy naked options. In doing so, you are assuming that you are smarter than the market, and most of the time, the market is efficient enough to reflect all of the widely known information. So unless you went out for drinks with Bill Gates and made him spill some top secret info, you have no realistic play on profiting from naked options. Off course, if you live too far from Las Vegas or Atlantic City, you can use your broker as a local casino and gamble on the stock market, but the results are going to be similar to playing black jack in Ceasar’s Palace. And it’s addictive.