Paul Buckley ’17, Alex Gorgoni ‘17
Many investors look for ways to diversify their portfolios. A very popular type of security, an option, is a great way to do so. Options are very versatile and for this reason have become very popular to investors of all mindsets. However, like all investments, options contain risks and an inexperienced trader could find themselves in a hole with option contracts. It’s important for the novice investor to understand the ins and outs of options, along with any risks that the purchase of a contract pose.
Put simply, “an option is a contract that gives the buyer, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.” Options have binding contracts that the buyer must adhere to.
In many cases, the purchase of a house is used to help illustrate an options example. Imagine you are shopping for a home and find one that you think you love. You make an agreement with the seller; you tell him that before he puts the house on the market at the end of the month, you will give him $400,000. The seller accepts your claim and says he would like a down payment of $10,000.
This agreement could work out very well for you. If the word gets out around town that the seller’s home is going on the market at the end of the month, maybe demand for the house will rise and the market value would then be closer to $500,000. In this case, you would make out very well, saving almost $100,000.
Alternatively, say you do some research online about the neighborhood. You find out that the man living next door was accused of a series of crimes 10 years ago and realize that maybe starting a family next to him isn’t in your best interest. You contact the seller and tell him you are no longer interested in the deal. Due to your agreement with the seller, he still gets to keep your down payment and you are out $10,000.
This example helps show both the benefit and the danger of an option. If the market value of an asset suddenly rises, your option contract allows you to purchase the asset at the price agreed on in the contract. Additionally, if you opt out of your contract, you are still liable for the down payment (known as the premium).
Many things in finance have their own lingo; options trading is no exception. There are two types of options, puts and calls. A put gives the owner the right to sell the asset at a specific price within a specific time window. Buyers of these puts hope that the price of the stock will decline in value before the contract comes to a close. A call gives the buyer the right to purchase the asset at a specific price within a specific time period. The buyer of a call hopes that the price of the asset will skyrocket before the contract comes to a close.
In the money refers to a call option that has a share price higher than the strike price (the price at which the underlying asset can be bought or sold). Conversely, for a put option, in the money refers to an option that has a share price lower than the strike price.
Options are a great way to diversify one’s portfolio. The risk involved may be worrisome for investors (especially beginners) but the reward of a successful contract is enough for investors to keep purchasing more and more contracts.