Wednesday, March 27, 2013


Options are a derivative security.  They derive their value from an underlying asset.  Options are in two major classes.  Call options and Put options.  Call options allow you to buy shares at a specified price.  Put options allow you to sell options at a specified price.

Why would you ever want to do this?  Say you hold 10,000 shares of Estee Lauder worth $640,000 at $64/share.  You plan on holding these shares for a long time, but are a little bit worried about the down side risk.  You would purchase put options.  You could purchase Put Options expiring April 19th with a strike price of $60 for 35 cents/share.  To cover all of your holdings would cost you $3500.  If the stock tanks to $55/share, your options would be in the money and you could sell your options at the higher price or exercise your options and collect $5/share or $50,000.  Your shares went down $90,000, but you collected $50,000 back from your put options.

A call option is the opposite.  Say you think Estee Lauder is going to go up, but you don’t have the capital to buy 10,000 shares.  You could purchase call options at a strike price of $70 expiring April 19th for 10 cents/share.  For $1,000 you could control 10,000 shares and if the stock goes to $71, you could sell your options at the new valuation or exercise your options and collect $10,000.

For every option buyer, there is an option writer.  Writing options can be more risky as there is no downside protection.  Buying options has limits as you have the right, but not the obligation to exercise your options.  Writers collect premiums and make money when the strike price is not realized, $3500 in the first example and $1000 in the second example.  

Options trading strategies can get pretty exotic.  Some simple ones include Bear Put Spread, Bull Call Spread, Butterfly Spread, etc.  All of these are a way to make money based on a theory of how an underlying asset is going to perform.  These spreads often mitigate downside risk and upside return.

Options trading can be done from your brokerage account, but it needs to be set up as a margin account.  These are usually reserved for “savvy” investors, but it is not hard to convince anyone that you deserve a margin account.  Options are traded inter-day and are a liquid market.

The key components to evaluating an option are expiration date and strike price.

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