How Options Contracts Work & How You Can Benefit From Them

Even if you’ve been interested in investing for a while, you may not have heard about options contracts. There’s a reason for that—very few investment or financial advisors offer them to their clients. Not because they aren’t profitable, but because few people have the needed experience and knowledge to trade them correctly. 

The experts at Alpha Wealth Funds have decades of experience with trading using options contracts, or “options.” They have a place not only in Hedge Funds that are accessible only to Qualified Accredited Investors but also in Separately Managed Accounts (SMAs) that everyday people can take advantage of. SMAs are what many people think of when the term “investment accounts” is mentioned—they include cash brokerage accounts, IRAs, inherited accounts, rolled over 401ks, and so on.

For example, last year, options contracts added an average of 8% to the cash brokerage account at AWF. This passive income is a return on top of the base investment performance, making it great downside protection and an extra source of capital to cover advisor fees. 

Keep reading to learn more about options contracts (options), how they work, and the benefits you get from having them in your portfolio. Let’s get started.

What Is an Option?

Options are essentially financial contracts that give buyers the option to purchase or sell an asset at an agreed-upon price. In the investment world, options are often based on the value of underlying securities, for example, stocks. As financial derivatives, options allow—but do not enforce—buyers to buy or sell an asset at a previously decided price.

It’s vital to note that options are a versatile financial product that comes with their own set of risks when investing. Just like with stocks, options come with a standard warning that there is always a chance to lose the investment. 

There are also different kinds of options. Call options enable their holder to buy an asset at a stated price within an arranged timeframe. However, put options enable their holder to sell the asset at a stated price within a specific timeframe. Thus, call option buyers generally expect the stock price to rise, and put option buyers expect the stock price to fall.

There are many reasons why traders buy and sell options. One of them is that options speculation enables a trader to hold a leveraged position for a particular asset at a lower cost than buying a share of the asset. Typically, investors use options as a way to reduce or hedge the risk exposure of a portfolio. 

Using Options for Leverage

As already mentioned, options are often used for hedging purposes; however, they can be used for speculation as well. Options tend to cost only a fraction of what the underlying shares would.

That means that using them is a form of leverage, which allows the investor to make a bet on a stock without selling or purchasing the shares. But keep in mind that this privilege comes with the obligation to pay a premium to the party that’s selling the option.

What Is the “Contract”? 

The “contract” part of options outlines the terms of the agreement between two parties that may potentially make a transaction on an underlying security. Options contracts cover both buyers and sellers.

A contract’s terms may outline the details of the underlying security, the transaction price, and the contract’s expiration date. The industry standard is that one option contract is for 100 shares. If you own 100 shares of the stock, it’s called a “covered” contract (for example, a covered call), and if you don’t own the stock, it’s called a “naked” contract (for example, a naked put).

Types of Options Contracts 

There are two distinct types of options contracts: calls and puts. Both of them can be bought as a way to speculate on the direction of the hedge exposure or security. Along with that, they can be sold to generate income. 

Typically, call options can be purchased as a leveraged bet on the appreciation of a stock or index. Alternatively, put options are bought as a way to profit from price declines. As the buyer of a call option, you have the right but not the obligation to purchase the number of shares covered in the contract at the strike price (the agreed-upon price). Buyers also have the right—but not the obligation—to sell the shares at the strike price specified in the contract. 

Option sellers, also called writers, are obligated to transact their side of the trade if the buyer decides to either execute a call option to buy the underlying security or a put option to sell it. 

Options Vs. Stocks 

Even though stocks and options are closely related, they are actually quite different things, especially when considering the risk you need to take. 

Often, stocks are thought of as a lifetime investment, as they continue to exist for as long as the company exists and remains publicly traded. It’s true that in any year, their price can fluctuate significantly. However, over time, its performance follows the trajectory of the business. If the company’s earnings continue to grow, the stock will typically rise over time. If its profits fall, the stock will also do the same. If the company goes bankrupt, the stock will essentially cease to exist.

On the other hand, options have a fixed life and designated expiration date, after which their value is settled among investors. The value of an option has a tendency to decline over time, bringing the concept of “time value” into play. In other words, the value of an option is based on the underlying stock’s performance and the expiration date of the contract.

Both varieties of options require the buyer to pay a premium in order to own an option contract; however, the differences between them should be reiterated:

• With a call option, when the stock price goes up, the call option also rises in value. So in most cases when buying a call option, you’re expecting the stock price to rise.
• A put option tends to increase in value when the stock price goes down, so if you’re buying a put option, you’re expecting the stock price to start dropping. 

Rundown of Similarities and Differences Between Stocks and Options

One similarity between stocks and options is that both can be traded any time the market is open. Stocks and options are also taxed the same for the most part—they can both be taxed short-term or long-term, depending on the holding period.  However, there are some specific differences between stocks and options that lead to an additional tax form for most options traders (Form 6781: Gains and Losses From Section 1256 Contracts and Straddles). When reporting on investments, 60% of gains (or losses) are treated as long-term, and 40% of gains (or losses) are treated as short-term.

Some of the primary differences between stocks and options are as follows:

• Options tend to have a higher risk and higher potential rewards and losses (within a certain timeframe).
• A stock can have a potentially infinite lifetime, while options always have a limited lifetime.
• Unlike trading stocks with large online brokers, options typically come with a brokerage commission.

The Benefits of Options Contracts 

The idea that you can make a profit with options contracts is what lures many investors. However, that’s far from being the only benefit they offer. Let’s take a look at all the key advantages of options contracts: 

• Options can provide high returns over a short period of time and can thus grow your capital relatively quickly.
• Options prices are extremely volatile, but you can use that to your advantage and make good profits if you’re an investment expert (or getting advice and guidance from an expert).
• They are liquid, meaning that you can exchange them for cash whenever the market is open.
• Even though they’re generally considered risky, low-risk options strategies can enhance your returns as a stock investor.
• There’s a chance to qualify for lower long-term capital gains tax rates with long-term options; however, that’s not offered on all stocks. 

It’s vital to remember that seasoned financial professionals are often needed to successfully use and trade options. This is unlike other trading strategies in many ways, but it’s because options are high risk. If you don’t have the needed knowledge or experience, purchasing them could lead to big losses. 

In the hands of professional investors, financial advisors, and traders who have worked with options for years and know how to trade them properly, options can provide passive income and help secure your portfolio.

If you’ve already dipped your toes into investing, but you want to go a step further, then reach out to an experienced financial advisor and ask them about options contracts—if they know what they’re doing, they can help guide you through the process and build your investing portfolio. The knowledgeable Certified Financial Planners at Alpha Wealth Funds have years of experience and are ready to help.

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Michael Torrence

Calendly link https://calendly.com/mt-awf/intro Work: 435.658.1934 Contact: 330.284.3211
Michael Torrence – Investment Advisor Representative: Michael was born and raised in Ohio and attended The Ohio State University. After College, he was commissioned as a 2ndLt in the United States Marine Corps. He attended his initial training in Quantico, Virginia, then graduated at the top of his Primary Aviator Class and was selected for the Strike (Jet) Platform.

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PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. All investments involve risk including the loss of principal.