Are Options right for me?
As defined, an option “is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset at a specific price on a specified date, depending on the form of the option.” There are two types of options, calls and puts. Each option is a contract between a buyer and seller which gives the buyer the right to buy or sell 100 shares of the underlying stock. The contract establishes a certain price, referred to as the strike price, at which the contract may be exercised or acted on. The contract also establishes an expiration date by which the option must be exercised. Upon expiration the option no longer exists and has zero value.
When an investor buys a call option, he/she acquires the right to buy the underlying stock at the strike price on or before the expiration date. The seller or writer of the call option is required to sell the stock at the strike price upon the direction of the option owner. A put option works the same way except that the right purchased by the investor is one to sell, not buy, the stock at the strike price on or before the expiration date. The seller or writer is required to buy the stock at the strike price upon the direction of the option owner.
The price or value of an option is calculated using a rather complicated pricing formula known as the Black-Scholes pricing model. For our purposes here, the total value of an option can be found in the sum of two components – intrinsic value and time value. The intrinsic value of an option is rooted in the difference between the market price of the underlying asset “S” and the option strike price “K”. Options are commonly referred to as in the money, at the money or out of the money. A call option is in the money when S>K, at the money when S=K and out of the money when S<K. A put option is in the money when S<K, at the money when S=K and out of the money when S>K. The time value is the difference between its current price and the payoff to be received if it were to be exercised. Time value is greatest at time of writing and least (or zero) at expiration. For example, if the stock in Company ABC is trading for $25/share and the ABC (strike price of $20) call option is trading at $7, then the option has an intrinsic value of $5 (S– K = $5) and is in the money. The time value of this option is $2, which is calculated as $7 - $5 = $2.
Options are not suitable for all investors. Most financial advisors will only use option strategies with their most qualified and experienced clients and then only after receiving specific approval. If you are considering employing an option strategy for the first time, it is suggested that you proceed with due caution. Using options to speculate can be risky and should not be undertaken without proper oversight, limits and financial reserves. There are, however, several options strategies which might be suitable. Purchasing call options to provide increased diversification by adding exposure to a particular asset class or sector is one such strategy. Using out of the money put options to protect unrealized portfolio gains is a defensive strategy similar to buying insurance. In this case, consider the option contract price as your insurance policy premium and the difference between the stock price and strike price as your deductible.