Today Malay Shah gave a great and informative presentation on options derivatives and their uses. Here are a few of the basics he covered:
- Disclaimer: options involve risk; know what you are doing before beginning trading
- Options are derivatives that give the owner the right, but not the obligation, at a later date to buy or sell a security, usually a stock, at a later date.
- There are two types of options in the markets: calls give the ownerthe right to buy a security; calls give the owner the right to sell the security
- The three main components of Options are: strike price, premium, and expiration date
- Strike Price: The price that will be paid for the security in the future
- Premium: the extra price that you must pay for the right to buy or sell the security later (in other words the price you pay for the option)
- Expiration Date: the date that you would buy or sell the security if you owned the option
Options are a great way to hedge you bets on stocks. Lets take this example that Malay included in his presentation. There is a house that you can buy for $200,000. You could also buy an option on that house (in this case it would be a call option) for $3000. There are two scenarios. In scenario A the house becaomes worth much more than the current price of $200k. If you had bought the house you would have made a significant gain. However, if you had bought the option you would have made $3000 less, which is really not much less. In scenario B, the house's value goes to $100k. If you had bought the house you would have lost half your money. However, with the option you wouldn't buy the house and you would only lose the $3000 he paid for the option. As you can see, options can trim down potential profits, but they can also keep you from losing much more on the downside.
Now on to some more advanced options strategies. Writing covered calls is the action of selling call options on stocks that you own. This is meant to be done on stocks that you believe will go up in the long term but not necessarily in the short term. You can think of selling covered calls as charging rent on your house. As long as people want to buy your options you can collect the premiums on theoptions you are selling. However, the catch is that if the price goes above the strike price you are going to have to sell your stock. This is a good way to increase returns on a "flat" stock. Another strategy is the Bear Split-Strike Combo. This involves buying a put option at a low strike price and selling a call option at a higher price. This is a bearish stance on a stock. You make money if the stock goes down, but if the stock goes up your losses are unlimited. Check out the chart below for the Bear Split and other strategies.