Options: Are They an Option and How Do They Actually Work ?

By: Dr Norman D - September 15, 2020 09:43am EST
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Why don’t I sell (called ‘write’) options and just reel in the premiums?
Why don’t I sell (called ‘write’) options and just reel in the premiums?

I recently attended an online webinar. One of the speakers was an Australian who showed how you could make fortunes with options. The market could go up or down he said and with options you would get rich-quickly. In weeks you could make many times your investment. You could buy his course which normally costs $10,000 for only $6,000. One wonders why he is selling courses if he can make himself rich so easily.

Here at Macrotomi , we don’t sell anything. We are only interested in financial truth and objectivity. In theory of course, it is possible to make a lot of money out of options. In practice it’s a very different thing. What is an option?

An option is a derivative, ie it is a financial instrument which is derived from the value of something else, whether a stock, or stock index, a bond, a commodity, a currency or even on derivatives of these, like futures.

I will restrict the rest of this article to options on stocks but the principles of all options are the same.

An option is a financial instrument which gives the holder the right (but not the obligation) to buy or sell a stock at a specified price over a certain length of time. Options to buy are termed ‘call’ options while options to sell are termed ‘put’ options. The price at which they can be exercised is called the strike price. They are issued with durations from 3 months to a year. Options with a longer duration, often up to 5 years are called ‘warrants’.

The price of an option is determined by two things:

1) the strike price (the price at which the option can be converted into shares) and
2) the length of time it has left to run.

Time is money and since you have more time to achieve your target with a longer dated option, it will cost you more. This is called the ‘time premium’.

Call Options (expect share price to go up)
Let’s say Apple is trading at $100. If you are holding options to buy 100 shares at $90 (the strike price), you can buy 100 shares for $9000 and sell for $10000 and make $1000 less charges. Options are tradeable so you can very often just sell the options unless you actually want to exercise them to hold the stock. You do of course then have to find the money to buy the stock at the exercise price. This is an example of a call option.

Put Options (expect share price to go down)
If you bought a put option to sell Apple shares at $90 and they went down to $80 then you could sell 100 shares at 90 for 9000 and buy them back at 80 at a cost of 8000 and once again have 1000 profit. You could of course just sell the option as well. This is an example of a put option. Options themselves obey the laws of arithmetic. Unfortunately the underlying security, unless it’s a bond does not.

This field has a lot of jargon.

From our above example let’s say you bought a call option (you expect the share to go up) for Apple at 110. This option can only realistically be exercised if Apple moves up to 110. It is said to be ‘out of the money’ and its value is time premium only.

So, one year duration would be more expensive than if it was 3 months, as there would be a greater probability (the longer you wait) of Apple stock exceeding the 110 strike price and be ‘in the money’. 

Similarly a put option trading below the price of the stock would be ‘out of the money’ and if it was above the price of the stock it would be’ in the money’.

Options that are ‘in the money’ have therefore both an exchange value and a time value. The time value is referred to as the ‘time premium’. This cost of an option is relatively small in comparison to its value if the underlying security moves favorably, ie it has huge leverage.

Leverage always comes with risk but it you are buying options that risk is limited to what you paid for the option. However 95% of both put and call options expire unexercised and worthless. It’s like buying insurance on an appliance which does not break. The money is lost. Of course you can only lose what you paid for the option, so you know your total risk.

When you discover this you think “wow”, its like being in the insurance business. Why don’t I sell (called ‘write’) options and just reel in the premiums? The reason you don’t want to do that is because when you write an option where you do not own the underlying security, these are called ‘naked options', your risk is unlimited.

It’s like insuring San Francisco shortly before the big earthquake hits. From personal experience, I have written naked puts and luckily managed to buy an offsetting option.It can be terrifying.

If you foresee market volatility it may be profitable to buy a put and call option on the same stock for the same due date and strike price. You can then profit if Apple goes up or down. In a steady market which goes no-where your options will just expire valueless.

It’s obvious that it is possible to buy a virtually unlimited combination of puts and calls and write them as well. There are books written on this and option traders talk of ‘straddles’, ‘collars’, ‘butterflies’ etc. Writing an option where you own the underlying stock is called a ‘covered’ option. It’s an apt term since it is also used before engaging in certain intimate activities.

After a prolonged market downturn options help with generating income. Let us say the market implodes and Apple stock falls to 30. You suspect it will rebound but do not know when of course. You would buy the stock at 30 and write ‘out of the money options’ at 40 for say a 6 month period and collect the premium and keep doing this as long as Apple was below 40. If Apple goes above 40, the shares will be called away from you at 40. You therefore lose any opportunity for further profit on this purchase. If the price of Apple stock continues to fall at least your losses are offset somewhat from the option sales. You cannot sell the stock on which you have written a call option unless you buy an offsetting call option.

There is one final consideration. There are two main types of options, ‘American’ and ’European’. American options can be exercised into the underlying security at any time. European options are commonly issued on ETF’s and indices and can only be exercised shortly before expiry. This is not usually an issue since options are tradeable. Don’t buy expensive trading courses. Read about option basics online and use the course money for trading.

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