Sound Advice: March 22, 2023

Options Explained

The word Options is often viewed as a scary word by investors.  It has an aura of speculation and gambling, although a better description might include increased risk.  In many cases, that’s an accurate assessment, but there’s at least one situation where the use of options can help reduce risk.

In plain English, an option is a contract between two parties that gives the buyer the right to buy or sell stocks at an agreed-upon price during an agreed-upon period.  An option to buy is a Call.  An option to sell is a Put.  There are a number of more complex variations.

An investor interested in buying a Call expects that the underlying stock will rise above a specified level during a set period of time.  So if Stock A is currently selling at $50 a share and that investor thinks the stock will climb to $60 or higher within a year, one appropriate Call option might be an agreement that allows the investor to buy at a set price of $55 (strike price) before the expiration of the agreement.

In that example, since the stock would be selling significantly below the strike price, the cost of the Call option would be low, perhaps $2.  If the option would cover 100 shares, the cost would be $200.  If the stock rose to $58 during the period, the investor could exercise the option and buy the stock at $55 for a total cost of $5,500.  The stock could then be sold for $5,800, which after deducting the cost of the option would yield a profit of $100, a gain of 50% on the cost of the option.

If the stock does not climb above the strike price, the option would be worthless upon expiration.  If it does, the investor would not be obligated to exercise.

A Put option is the exact opposite.  An investor buying a Put would expect a certain stock to drop below a certain level in a specified period.  The possibility of profit would increase as the stock’s price dropped.

One useful Put option is a Protective Put, which is especially appropriate for investors with concentrated positions that have low cost bases.  In these situations, there are often substantial unrealized gains.  To protect against the possibility of significant price erosion, an investor would buy a Put covering the existing position.  The result of a selloff in the stock would be offset by a corresponding gain in the value of the Put.

In addition to buying Calls and Puts, investors can sell Calls and Puts, which in effect are bets against the stocks moving above or below the strike price. There are more complex instruments such as Straddles and Collars involving multiple transactions to limit risk, though they also limit potential profits.

N. Russell Wayne, CFP^Ò

Any questions?  Please contact me at nrwayne@soundasset.com