So just what exactly is an option contract? It’s basically an agreement to buy or sell a specific amount of a particular underlying security. Options come in two types, calls and puts, and you can buy or sell either type. This is akin to being able to go both long and short a stock, essentially betting on either the upside or downside potential. That’s the short form explanation. They have all kinds of exotic combinations known as bull and bear spreads, straddles, and strangles, covered calls and naked puts just to mention some of them.
Most investors focus on the two basic types; calls and puts. But the most important type of information I am going to share with you is that most investors lose money on options.
Buying and Selling
If you buy a call, you have purchased the right to buy the underlying equity or vehicle at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying vehicle on or before expiration. So why would you do that? In the case of buying a call, you believe you can profit from a rise in price. A put is just the opposite. You hope to make profit by a decline in price. As the option holder, you also have the right to trade the option to another buyer during its term or to let it expire worthless.
The situation is different if you write or sell an option. When selling a short option position, as the writer you are obligated to fulfill your side of the contract if the holder wishes to exercise the contract. When you sell a call as an opening transaction, you’re then obligated to sell the underlying vehicle at the strike price. When you sell a put as an opening transaction, you’re then obligated to purchase the underlying instrument. Keep in mind, as a writer you have no control over whether or not a contract is exercised. And remember, that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market, as a writer you can purchase an offsetting contract, provided you have not been assigned, essentially canceling out your outstanding obligation. To offset a short option position, you would enter a “buy to close” transaction.
So where does the profit come in? When you hold a call option, it’s profitable or in-the-money if the current market value of the underlying stock is above the exercise price of the option. A put option is profitable or in-the-money if the current market value of the underlying stock is below the exercise price. If an option is not in-the-money at expiration, the option is assumed to be worthless. Note: 76.5% of all options end up just that, worthless, according to the Chicago Mercantile Exchange.
When buying or selling options, you need to understand several factors that influence the perceived value of the contract. They include supply and demand in the market where the option is traded, what’s happening in the overall investment markets and the economy at large, and the identity of the underlying instrument. How does it traditionally behave? Is there an upcoming dividend or stock split? Volatility is also an important factor; since investors profit by gauging how likely it is that an option will move in-the-money.
Pros: Options have a wide variety of benefits when used correctly. They can provide you with the flexibility you need in almost any investment situation you might encounter. Puts can protect your current holdings from a decline in the market, calls can be used to generate income in a flat market, naked puts can be used to buy attractive stocks at lower prices while generating a little income in the process, and options in general are a good (but potentially risky) way to control a large number of shares of a stock without using a large amount of capital.
Cons: Options can be risky! Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998 and 1999), an average of 76.5% of all options held to expiration at the Chicago Mercantile Exchange expired worthless (out of the money). This average remained consistent for the three-year period: 76.3%, 75.8% and 77.5% respectively, as shown in Figure 1. From this general level, therefore, we can conclude that for every option exercised in the money at expiration, there were three options contracts that expired out of the money and thus worthless, meaning option sellers had better odds than option buyers for positions held until expiration.
An excerpt of “The Investment Survival Guide”