Understanding Options (part 1) – Options Are Complicated For A Reason

Confusing street signAnybody who’s ever taken a look at options is well aware that, at first glance they appear to very complicated. Terms like calls, puts, derivatives, strangles, LEAPS and others, all seem to confuse the average investor. Why not use terms like ‘buy option’, ‘sell option’, etc.? This is part one of a multipart series in which I will introduce you to options, help you to understand them and teach you how to use options to diversify your portfolio.

Why options are complicated

I believe options consist of such obscure names and descriptions in order to keep average investors away. The reason for this is simple. When you add random, irrational variables to a formula, the outcome becomes much harder to predict.

Now, apply this same theory to the securities markets.  Somebody that’s brand new to investing has a higher chance of making a mistake or purposely making an investment that no rational investor would make. The money that goes into options is considered “smart money” and these complex traders don’t want you messing up their system.

Understanding options

Once you get passed the terminology, options are actually very easy to understand and there are only a few key points you need to memorize. Once you comprehend the basics, you can apply those principles to any options strategy to discover its intentions.
The value of an option is derived from the combination of other factors – the price of a security, time until expiration and the strike price.  These variables are the same for calls and puts. These five terms are the only ones you need to memorize for now.

  • PRICE – This is just the current price that a security is trading at. The security can be a stock, ETF, currency, mortgage and just about anything else that’s traded.
  • TIME – Each option contract will expire at a certain time in the future and that time has value. Standard options will expire every month.  For example, if you buy December 2012 option, that option will last until the 3rd Friday in the month of December. There are also options that expire every week and every quarter but we won’t get into those here.
  • STRIKE PRICE – Each option contract enables you to buy or sell a security at an agreed upon price. That price is referred to as the strike price.
  • CALL – A call option gives you the right to BUY a security.
  • PUT – A put option gives you the right to SELL a security.

The matrix below outlines the most important factors that you must comprehend. What it says is that the buyer/holder of an option has the RIGHT to use his option and the seller/writer has the OBLIGATION to fulfill the buyer’s right. This concept is very simple, but it is the single most important thing you must understand when trading options.  Once you understand this, you can evaluate even the most complex option strategies and know exactly what the optimal outcome would be.

This matrix also illustrates the most basic strategies – if you think a stock will increase in value (bullish), you buy a call or sell a put and if think a stock will decline (bearish), you buy a put or sell a call.  When describing option combinations (spreads) I use this same matrix, but I will add a few rows and columns.

Call Put Option Matix

Option risks

Options introduce a new risk factor that is not relevant when simply buy stocks or other investment products – expiration.  Unlike a stock, the option contract you are buying or selling is only good for a certain amount of time.  If you buy a call or a put and the security does not move in the direction you are betting on by the expiration period, you lose your investment. There is no residual ownership after expiration, the contract is completely gone.  However, this risk can work out to your benefit when your selling options.

Value of options in your portfolio

Options will greatly benefit your portfolio if used correctly. There are three basic investment objectives that can be obtained using options: income, trading and speculation.  Adding options to your portfolio can help you achieve these goals while lowering your risk or increasing your risk – whichever you choose. As stated before, this will be a multipart series in which I will explain all of the different options strategies in detail in coming posts. Until then, grasp the concept shown in the matrix above and then you’ll be able to apply that knowledge to any options strategy.

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Comments

  1. I’ve sold several covered calls so far. That’s all I can handle in terms of options risk. But, I think options provide many ways to profit, if you can predict the stock move with reasonable degree of certainty. I am also studying LEAPS right now. Your article provides wonderful intro for a novice like myself.

    • Covered calls are a great way to generate some income in today’s environment of low interest rates.

      You can make a lot of money if you make the right “bet” when speculating with options, but as you said, the risks can be great. In a later strategy, I’ll discuss spreads which will give you the ability to still make that speculative bet while lowering your downside risk.

  2. Nathan Duke says:

    Good article. I know at least 30 people that I’ll pass this along to!

    • Awesome! My goal is to lay the ground work then show how easy it is to understand complex option strategies with only a few basic building blocks.

  3. I’m with Shilpan. Covered calls are a nice, basic strategy I’ve used to make money. Collars are nice, but in most instances I’ve found them difficult to execute. Can’t wait for some of the more complex strategies to see what I’m missing!

    • How does your firm require you to enter collars AverageJoe? If you have to enter each leg separately, they can be a pain. However, if you’re able to enter the collar as one trade, the execution is greatly simplified.

  4. JW, loved the article. Thanks for laying the ground work. I’ve never executed options and not sure if I ever will….but I do want to be knowledgeable about it.

    • Options are not suited for all investors, but it’s always good to understand how they work. As you’ve said John, even if you don’t trade them, knowing how the work can be very beneficial.

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