Options are a type of investment that can add a layer of diversification for sophisticated investors. They are versatile, yet complex and extremely risky. This article will not make you a professional, but it will give you a basic idea of what options are, how they work, and what they can do for your investment portfolio.
Options and Derivatives
Options belong to an investment family called derivatives. They get their name because their value is derived from the price of an underlying asset. The value of an option comes from an underlying stock. Other types of derivatives include futures, forwards, swaps and mortgage-backed securities.
How Options Work
An option is a contract. This contract gives you the right to buy and sell the underlying stock at a set price on or before a certain date. The price you can buy or sell at is the strike price. You must use an option before the expiration date. This is the date on which the option expires and is no longer valid. The price you pay for the option is known as the premium. If you purchase an option, you have the right, not the obligation, to exercise it. You can let it expire worthless. If this were to happen, you would just lose the amount you paid as the premium.
There are two main types of options. They are:
- Call Options: With this option, you have the right to buy a stock at a specific price, before the expiration date.
- Put Options: This option gives you the right to sell a stock at a specific price, before the expiration date.
Buying and Selling Options
If you buy an option you are a holder. If you sell an option you are a writer. There are 4 things that you can do with options. You can buy calls, sell calls, buy puts, and sell puts. We will go over what all of them involve.
- Buy Call: If you buy a call, or you are a call holder, you have the right to buy a stock at the agreed-upon strike price. With this type of option, you limit your risk. The most you can lose is the premium.
- Sell Call: If you sell a call, or you are a call writer, you are obligated to sell the stock at the strike price. This happens if the call holder chooses to exercise the option. Because you are under contract to sell, it leaves you open to unlimited risk. But if the call is never exercised, your gain will be the premium the call holder paid.
- Buy Put: If you buy a put you are a put holder. This gives you the right to sell stock at the strike price. The most you can lose is the premium.
- Sell Put: If you sell a put, you are a put writer. This obligates you to buy the stock at the strike price if the put holder exercises the option. This leaves you open to unlimited risk. If the buyer never uses the put, your gain will be the premium the put holder paid.
What Options Can Do for You
The main benefit of using options is for hedging. Hedging is an investment strategy that helps you to reduce risk at a reasonable cost. It works as a kind of insurance policy to help you limit your investment losses. For example, if you are worried that a stock you own may drop in price you can purchase a put that will allow you to sell that stock at the strike price, no matter how low the price of your stock drops. It is important to keep in mind that this strategy does not get rid of risk, all investments carry risk in one form or another. But hedging may be a strategy that can help you mitigate your risk.
If you have an interest in diversifying your investment portfolio, met with an experienced advisor who can help you do so in a way that is best for your needs.
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