An Introduction to Stock Options
Stock derivatives have been around for decades as investors find creative ways to hedge their investments or to take advantage of market inefficiencies and price volatility. At the same time, derivatives do have their fair share of risks. Numerous speculators and traders have lost money trading these on a short-term basis.
In this three-part article, I will be providing a brief background on stock options, one of the more common stock derivatives, and whether we, as investors, should consider it part of our investment strategy.
This will be split into (1) Call options, (2) Put Options, and (3) Using options as an investment strategy.
But first, what are equity derivatives?
Derivatives, as the name suggests, are contracts between two or more parties whose value is derived from an underlying asset.
In the case of stock derivatives, the asset in question is a particular stock or a stock index.
There are a few different kinds of derivatives in the market today, such as stock options, warrants or contract for difference (CFD).
Stock options are contracts between two parties that give the buyer the right, but not the obligation, to buy or sell a share or index at a predetermined price.
There is an expiration date on the contract which, if passed, nulls the agreement. A contract can, hence, expire worthless if the buyer of the contract does not wish to execute the order by the expiration date.
There are two types of a stock option, namely, Call and Put stock options.
The call option
The call option gives the buyer of the contract the right to buy a predetermined number of shares at a specified price known as the strike price. This is useful for an investor who believes the stock will rise in the future and therefore locks in a price that he is willing to pay for the stock. If the share price rises above the strike price, they will make a profit by executing the call option.
For each option contract, there is a seller or writer of the contract at the other end of the deal. They sell this contract for a premium and collect this fee, regardless of the option contract being executed or not. The seller of the call option is, however, obligated to sell the shares at the strike price if the option is executed.
Example of a call option
Mr. Lim buys a call option for Company X, which expires in one month. The strike price for the contract is $100. At the end of the month, the share price of Company X has reached $110 and Mr. Lim executes the option contract to buy the shares at $100. He may then wish to sell the stock in the open market for a profit of $10 or opt to hold the investment for a longer term. This is the perfect scenario for Mr. Lim as he had purchased the stock at a discount to the market rate.
On the other hand, if the price of the shares of Company X at the end of the month is below $100, Mr. Lim will decide not to execute the option and the contract will expire worthless. He then loses the premium that he paid for the option contract.
The Foolish takeaway
Even though the options market had only officially started trading on the Wall Street in 1973, their history dates back to thousands of years.
Options were used to lock-in prices for commodities such as wheat, grain or oil.
However, since then, these contracts have evolved to include other assets such as stocks and bonds.
As investors we should familiarise ourselves with stock derivatives as it can be used as a hedge or obtain a stock at a price we feel is appropriate.