Think Inc.
A forum for Hawaii's
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Think Inc.
A forum for Hawaii's
business community to discuss
current events and issues.
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'Options are a product of the devil, designed to confuse investors, make the poor poorer and the rich richer." Understanding options
Spend a few minutes in class decoding
the jargon of covered puts, calls and the long
straddle, then exercise your right to choiceBy Gunter Meissner
This notion is of course untrue. Options are not as complicated as many people think. There are a variety of uses, which can help increase returns and, more importantly, reduce the risk of companies and investors.
Before we discuss some simple ways in which an investor can use options, here are the basic features of options: An option is a right to a choice. Sometimes sports clubs buy an option on an athlete who is currently unavailable. Let's say the athlete does well and his market value increases.
Then the sports club pays the pre-agreed price for the athlete at the time he is available. If the athlete has done poorly or is injured, the sports club has the right not to acquire the athlete.
Puts and calls
In the stock market an option can be the right to buy a stock (call) or the right to sell a stock (put).Let's say you believe Microsoft will increase in the future, but you are not so sure. You can buy a call, which allows you to buy Microsoft within the next 6 month at $65. This $65 is called the strike price.
If Microsoft goes to $80, you will buy Microsoft at the pre-agreed price of $65. If Microsoft goes to $50, you throw away your option (it expires worthless).
However, a call option has a price. Let's say it is $2. So if your call expires worthless, you lose $2. But if Microsoft goes to $80, your profit is $80 - $65 - $2 = $13.
This limited downside potential ($2), but unlimited upside potential ($13 or more) is called the leverage of an option.
The leverage is also reflected in the fact that when Microsoft goes up by 10 percent, the call price will go up by much more, e.g. 30 percent. So the investor profits relatively more if the market increases.
But there is no free lunch, so there must be a catch. The catch is if Microsoft stays where it is or just goes up a bit, let's say from 60 to 61. In this case the call holder loses his $2, but the Microsoft stockowner makes $1.
Let's look at some option strategies. The first one, covered puts, is an important strategy in order to reduce stock price risk. It actually functions as a market support, since investors refrain from selling stocks if they eliminate their stock price risk when using the covered put strategy.
Strategy 1: Covered puts
Your Microsoft stock is dropping. You want to protect yourself against further losses, but at the same time want to participate if Microsoft recovers.The right strategy in this case is simply buying a put, which works as an insurance against a decreasing stock price.
If Microsoft drops, you are protected, since you can sell the stock at the agreed stock price (strike). If Microsoft rises, you participate in the rise, because you still own the stock.
For example, if you own one share of Microsoft and want to protect against a decrease of your stock but at the same time participate if Microsoft increases, you buy a put option with a strike of $65.
The put costs you $2. If Microsoft decreases to $50, you are protected, since you can sell Microsoft at $65. If Microsoft increases to $80, you will not use your put option. But you participate in the Microsoft increase, since you still own the stock.
Strategy 2: Covered calls
The stock market is going sideways and you want to increase your return.The right strategy in this case is selling a call on a stock that you own. If the market continues to go sideways, the call will expire worthless and you keep the call premium as additional income.
If the market unexpectedly rises though, you miss out on the increase, since you have to sell your stock at the strike price.
Let's say Microsoft has traded at $60 for a while and you believe it will continue to go sideways. You sell a call on Microsoft with a strike of $65 and receive the call premium of $2.
If Microsoft stays at $60, your additional income is $2. However, if Microsoft goes to $80, you have to sell it at $65, so you miss out on the stock's increase. There's no free lunch.
Strategy 3: Long straddle
If you believe that due to recent economic and political events, the stock market will be very volatile, you should buy a straddle. Buying a straddle means buying a call and buying a put.If the market increases strongly, the call will generate income; if the market decreases strongly, the put will generate income. However, if the market fluctuates only a little, the income from the call or put might be smaller than the price paid for the call and put.
For example, you buy a call with a strike of $65 and a put with a strike of $65. You pay $2 for the call and $4 for the put. If the stock goes $80, your gain is $80 - $65 - $4 = $11 on the call. If the stock goes to $45, your profit is $65 - $45 - $4 = $16.
However, if the stock stays at $65, you will not exercise your call or put and lose the combined premium of $4. Did we mention that there is no free lunch?
Option: The right to make a choice. Definitions:
Call: The right to buy a stock.
Put: The right to sell a stock.
Straddle: Buying both a call and a put on a particular stock.
Let's say you believe Microsoft will increase in the future, but you are not so sure. You can buy a call, which allows you to buy Microsoft within the next 6 month at $65. This $65 is called the strike price. Example:
If Microsoft goes to $80, you will buy Microsoft at the pre-agreed price of $65. If Microsoft goes to $50, you throw away your option.
Gunter Meissner is an associate professor of finance at HPU.
He can be reached at gmeissner@hpu.edu.
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