What Are Options?
Blog 1: What Are Options?
Sam Hooker
This blog seeks to educate the average investor on what options are and how to utilize them in your portfolio to maximize returns and minimize risk.
Options are often utilized by sophisticated investors who want to add income, protection or leverage. They are categorized into a larger umbrella known as derivatives. Like the word suggests, a derivative’s price is dependent on, or derived from the price of something else, usually the underlying asset. For this reason, it is much more difficult for analysts and investors to evaluate the fair market price of a derivative and they are often purchased on speculation.
Collateralized debt obligations (CDOs) and collateralized mortgage obligations (CMOs) also fall under the umbrella of derivatives and helped contribute to the global financial crisis of 2008. For this reason, Warren Buffet commonly refers to derivatives as WMDs. These instruments will not be discussed further in this blog, but it is important to know that many investors shy away from options because of the reputation of derivatives. Although more complex than purchasing stocks or bonds, derivatives are only risky when the underlying assets of the instrument are also risky. In 2007-08 these CDOs and CMOs were filled with junk bonds, and when the underlying asset went to zero the derivative also went to zero. If investors purchase derivative on safe, trusted assets, than if the underlying instrument increased, so will the option. Similarly, you can sell an option to capture any downside risk, but I will discuss this later in the blog.
The five components of an options contract that determines the value to investors is the underlying security, contract size, expiry day, strike price, and premium.
Underlying Security
The underlying security is obviously important to investors who want to evaluate these instruments because the price of the derivative comes from the price of the underlying security.
Contract Size
The contract size is generally 100 for all options sold over standardized markets, but would be important to investors if specified otherwise.
Expiry Date
The expiry date is important because it signalizes the last day that the investor has to exercise the option contract. If the expiry date is longer than the stock price would be expected to move more than it would over a short period of time. For that reason, options with a longer expiry date are more attractive, and thus more expensive, given all else is constant.
Strike Price
The strike price is also important because it specifies the price that the underlying security must rise above in order to exercise the option. An option with a strike price that is closer to the price of the underlying security will be more attractive to investors, and thus more expensive, given all else is constant.
Premium
Options premiums dictate how much the buyer will have to give to the writer regardless if the option is exercised. An option with a smaller premium will be more attractive to buyers of options.
To learn more about the basics of options: Click Here