Investing in Options Market

Introduction

Nowadays, many investors' portfolios include investments such as stocks, bonds, and mutual funds. But the variety of securities you have at your disposal does not end there. Another type of security, called an option, presents a world of opportunity to sophisticated investors.

The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index.

This versatility, however, does not come without its costs. Options are complex securities and can be extremely risky. This is why, when trading options, you'll see a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Despite what anybody tells you, option trading involves risk, especially if you don't know what you are doing. Because of this, many people suggest you steer clear of options.

The Law Offices of Robert Wayne Pearce, P.A. focuses its practice on securities, commodities and other investment disputes in courtroom litigation, arbitration and mediation proceedings. We have over 35 years experience representing domestic and foreign investors from offices located in Boca Raton, West Palm Beach, and Fort Lauderdale, Florida. We handle options fraud and other options stock broker misconduct claims. It is important for all investors to understand the fundamentals of investing and we are pleased to share some of the basics in investing in options to help you understand options and avoid disputes.

What Are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. The Chicago Board of Options Exchange ("CBOE") brochure is a must read before investing in options.

Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

  1. Buyers of calls
  2. Sellers of calls
  3. Buyers of puts
  4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

  • Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
  • Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Selling options is more complicated and can be riskier than buying them.

The Lingo

To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in‑the‑money if the share price is above the strike price. A put option is in‑the‑money when the share price is below the strike price. The amount by which an option is in‑the‑money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this tutorial.

Why Use Options?

There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation

You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made ‑ and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, its all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging

The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost‑effective way.

How Options Work

Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's Tequila Company.

Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break‑even price would be $73.15.

When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 ‑ $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits ‑ unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.

By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.

Exercising Versus Trading‑Out

So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised.

In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.

However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.

Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.

Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in‑the‑money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following:

Premium = Intrinsic Value + Time Value

$8.25 = $8 + $0.25

In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.

Types Of Options

There are two main types of options:

  • American options can be exercised at any time between the date of purchase and the expiration date. The example about Cory's Tequila Co. is an example of the use of an American option. Most exchange‑traded options are of this type.
  • European options are different from American options in that they can only be exercised at the end of their lives.

The distinction between American and European options has nothing to do with geographic location.

Long‑Term Options

So far we've only discussed options in a short‑term context. There are also options with holding times of one, two or multiple years, which may be more appealing for long‑term investors.

These options are called long‑term equity anticipation securities (LEAPS). By providing opportunities to control and manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on most widely held issues.

Exotic Options

The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject of options can be difficult to understand at first, these plain vanilla options are as easy as it gets!

Because of the versatility of options, there are many types and variations of options. Non‑standard options are called exotic options, which are either variations on the payoff profiles of the plain vanilla options or are wholly different products with "option‑ality" embedded in them.

Conclusion

We must emphasize that options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. Oftentimes options stockbrokers are not as knowledgeable or trustworthy as one might be led to believe. As a result, investments in options can be mismanaged, misrepresented and unsuitable investments offered and sold in violation of federal and state securities law or breach of a broker's fiduciary duty. Stockbrokers can also be held responsible for their negligence and failure to abide by commodities industry rules and regulations. At the Law Offices of Robert Wayne Pearce, P.A. we know the nature, mechanics and risks of investing in the options markets as well as the applicable laws, rules and regulations governing those investments. Please contact us for a free consultation if you believe you have been harmed by brokers misconduct in connection with your options contract investments.

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Contact The Law Offices of Robert Wayne Pearce, P.A., in Boca Raton to discuss your fraud or misrepresentation claim. The firm can be reached by phone at 561-338-0037, toll free at 800-732-2889 or via e-mail.

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