Once investors move on from basic equity trading, for purposes of seeking alpha, or leverage (investments that move up and down at a faster rate parallel to the market), it’s hard to get very far without making use of options. But where most companies only have one stock, and one price for that stock, dozens of options exist for each share with options available.
Options, in general, give you (hence the name) the option to buy or sell one share of a stock at a named price, whether or not that price is the market value of the security. Like futures, options also have an expiration, or execution, date. However, unlike the commodities futures, where a forgetful investor can suddenly find themselves drowning in a tanker-truck worth of orange juice, all an expiring option does is whatever it says it will do — for example, if you have an option agreement to buy 400 shares of Wal-Mart stock for $73 each at the end of August 2017, and you do not actively exercise it, it goes into expiration.
At that point, if the option is “in the money”, i.e. if you will break even or profit from exercising it because you are buying a stock for less, or selling for more, than its market value, your broker is obligated to carry out the option’s direction, possibly putting you on margin if you did not have enough cash in your brokerage account. This is not as scary as it seems, however, since you can immediately sell that stock (or buy to cover) to resolve the margin situation, and leave you with more cash than you started with.
If the option is “out of the money”, it then “expires worthless:” it simply disappears as if it never existed, since no one rational would use their right to pay MORE for a stock they could already buy for less, the exchange assumes that it is in everyone’s best interest to forget that that option exists, meaning that all you lose is what you paid for the option.
Just like commodities, while the original intent was for option contracts to run to expiration, it is possible to buy and sell the options themselves at market price, which can often be as low as 10c per share for options that are currently far out of the money, making them potentially an attractive investment if you’re expecting volatility or major shifts in particular stocks.
The first choice to make is between a put option and a call option. A put option gives you the right to sell shares you already have at a specified price*, ideally higher than the market price at the option’s expiration. A call option, on the other hand, gives you the right to buy shares at a specified price, ideally lower than the market price. In certain situations, it can even make sense to get matched pairs of options: a put and a call on the same shares, at different prices, in effect creating an instant profit if the required price is reached (or losing the cost of the options, if it isn’t reached).
*if you do not have these shares, and your put option expires, you will short the shares required to exercise the option, requiring you to buy to cover the short.
Option “Greeks”, additional data points included along with the price in an option quote, attempt to show future trends in the option’s price. Delta, the most important one, tracks the change in share price against the change in the option’s price. The closer delta is to 1, the higher the probability that the option will finish in the money (if delta is zero, that means that the share price changes and the option price doesn’t, usually because the option is so far out of the money that it’s already worthless).
Vega, also referred to as kappa or nu, quantifies the rate of change of the option relative to the VIX, a broad market measurement of volatility. Higher volatility in the share price, and a higher vega, meaning an option more responsive to volatility, are both associated with more profitable options.
Theta, the time derivative, tracks the change in the option’s value relative to the approach of the expiration date. Lambda, the leverage factor, represents how much the option’s value changes relative to the underlying asset. For common or vanilla options, this will always be 1 for an option in the money, and zero for an option out of the money; leveraged options, which greatly increase volatility and risk in exchange for higher profits off of small moves in share price, can have a lambda as high as 64.
If you’re lost, but would still like to invest in options and increase your portfolio’s potential to make bigger moves, consult a financial advisor who specializes in options.
