Tag Archives: options

Option Investing, Calls and Puts

If the stock market is not exciting enough for you or you want to earn a big payoff from a small investment, you might want to consider option investing. As the name implies, options grant the owner the option to buy or sell a specific stock. When you own a stock, the value of your stock moves up or down one for one with the stock’s price. That is not the case with options because a small move in the stock’s price can cause a much larger move in the price of the option. In other words, options are a leveraged bet on a stock’s movement.

Understanding Calls and Puts When Investing in Options

There are two primary types of options: a call and a put. A call is a bet that the underlying stock will go up in price while a put is when you bet that the stock price will fall. To find out more about calls and puts go here. The price of an option is called the premium. This is the amount you are required to pay just to enter the options agreement. For every buyer of a call, there is someone selling that call. Therefore, the buyer has the opposite view than the seller. In this way the options market is a zero-sum game because there is a loser for every winner. The buyer of an option pays the premium while the seller of the call earns the premium.

Timing

Unlike a stock, options expire. Each option comes with an expiration date, after which your option will expire either in-the-money or out-of-the-money. Options typically begin trading several months out but become more heavily traded as expiration approaches. If your option expires out-of-the-money, then you have lost the entire premium that you paid to buy the option and that money isn’t coming back. If the option expires in-the-money, congratulations. The more time until the option expires, the more valuable it is. As expiration approaches, the option value quickly falls.

Option Volatility 

option investing volatilityOptions prices depend on volatility. Volatility is the amount by which a stock can be expected to move up or down over a length of time. The bigger the swings, the more likely it is that the option will expire in or out of the money. You will notice that options on volatile stocks are more expensive than options on boring, less volatile stocks. The relationship between options and volatility helps determine the VIX which is an index of market volatility. Information about the VIX  and the VIX term structure can be found here.  Investing in options is all about volatility and is not for weak of heart.

Option Investing Strategies

Options can be used in combination. Various strategies can be designed using call and put options with different strike prices and times to maturity. The strategies have various names such as butterfly, collar and strangle. One popular approach to investing goes by the name ‘covered call’. In a covered call, the investor owns a stock and sells or writes call options on the stock. This allows the investor to earn some income from selling the calls in exchange for giving up some of the upside in the underlying stock.

A Losers Game

Are you considering options for your investment portfolio? Investors need to be careful trading and investing in options. This is true for several reasons. When buying a stock, an investor pays a commission to the broker and half of the bid-ask spread on the option.  For options, both of these costs are much larger. Many traders of options are sophisticated traders such as hedge funds. It is difficult to outsmart these traders at their own game. Options are difficult to value. Stocks with a wide following usually have heavy trading volume and therefore an agreed upon price. Options typically have much less trading volume, leaving their value much more uncertain. Pricing options typically takes sophisticated computer programs. Options are short-term investments and need to be monitored closely. Other types of options, such as Binary Options, are often loosely regulated. You can find more information on Binary options here.

In Summary

Remember, Option investing is not for the weak of heart. It is important to remember that while option investing is a way for an investor to place a leveraged bet on a stock, this type of investing can be very risky, to say the least. It is best not to invest the house or your retirement funds in options as the moves can be quick and painful. Call options are worth more when a stock goes up, while put options benefit from a stock price decline. You must be very careful when trading options and do not risk what you can not afford to loose, as the odds are stacked against you.