An Introduction to Stock Options and How They Can Enhance a Portfolio

Savvy individual investors use stock options to enhance their investment portfolios. Options can both increase the income a portfolio produces and reduce the risk of the overall portfolio. Before you can begin investing in options, however, you need to provide your broker with verification that you have both adequate net worth and sufficient knowledge about options to do so.

So, what exactly is an option?

An option is a financial instrument that gives the owner the right, but not the obligation, to buy or sell an asset at some future date for a price specified today.

Call Option

A call option gives the investor the right to buy the asset, while a put option gives the investor the right to sell the asset.
The price you must pay for an option is referred to as the option premium, and the pre-specified price at which the underlying asset can be bought or sold is called the strike price, or the exercise price, of the option. Standard options have an expiration date nine months from the date of issue, but there are options available with expirations two to three years from initial issue. These are known as LEAPs. American options, which will be the focus of this article, can be exercised any time prior to expiration.

An Example

To illustrate, let’s use an example from real estate. Let’s say you find a house that you really like. It is on the market for $350,000 and has most, but not all, of the features you want. You’d like to continue looking, but you don’t want this house to be sold out from under you in the interim, so you approach the owner of the house and offer him $10,000 to take the property off the market for six months. The two of you agree that should you decide to purchase his home within the next six months, you will pay him the current list price for the house.

This agreement constitutes a call option. You have paid $10,000, the option premium, for the right to buy the house for $350,000, the exercise price, within the next six months, the exercise period. If you don’t find a place you like better within that time frame, you can pay the homeowner an additional $350,000 and buy the house. (In an actual real estate transaction, the option premium is typically applied to the purchase of the house, and you would only have to pay the owner an additional $340,000, but this isn’t the way it works with a stock option, so we are modifying the terms of the real estate transaction for the purpose of illustration.) If, however, you find something you like better in the interim, you can simply let the option expire, forfeiting the $10,000 option premium.

In stock option terminology, the homeowner is known as the option writer, or option seller. Note that the option writer does not have an option. Should you decide to exercise your option, he must sell you the property for the agreed-upon price of $350,000, even if oil is discovered on the property in the meantime, causing its market value to soar. However, if you choose to let your option expire, he gets to keep the option premium and can put his house back on the market.

A call option on a stock works the same way. If you purchase a call option on, say, a pharmaceutical stock with a strike price of $50 and an expiration date 4 months from now, you own the right to buy that stock for $50 any time prior to expiration, even if that company discovers a cure for cancer in the interim and its stock price quadruples on the news. On the other hand, if one of the company’s drugs is found to cause cancer and its stock price plummets to $10 a share, you can let your option expire, in which case you will have lost the price you paid for the option, but no more than that.

Put Option

When you purchase a put option, the option premium you pay gives you the right to sell the underlying asset for the strike price at any time during the exercise period. So, if you buy a put option on Stock A with a strike price of $75 and an exercise period of 6 months, you can force the option writer -- who, by the way, is just another investor who has chosen to sell the put option -- to purchase Stock A from you for $75 a share, even if the actual market price of Stock A is $10 a share. As with a call option, you can let your put option expire if it’s not in your best interest to exercise it, in which case your loss is limited to the option premium you paid. Your loss is the option writer’s gain since he will pocket the option premium.
By InvestorGuide Staff

Copyrighted 2020. Content published with author's permission.

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