If you've ever worked as an employee of a company, you may have already come into contact with the idea of a stock option. These are often given to employees as rewards or as part of their severance package, though they can also be traded professionally by options traders.
In effect, an option is a contract between you and the person or corporation handing out the option, which gives you the right to buy or sell a specific asset at an agreed-upon price (the "strike price"). This makes options financial derivatives, as they are financial instruments derived from the value of an underlying asset. A typical option will consist of 100 shares in a stock, and you can buy it for a premium. Note that you pay the premium only for the right to buy or sell shares at the predetermined price in the future – you still need to pay the full strike price to buy the shares.
In contrast to futures investments, options do not obligate you to exercise them. This means if prices don't evolve the way you had hoped they would, you can choose not to buy or sell the stock and write off the options premium instead of being forced into a trade that may be significantly more unfavorable for you.
Call Options and Put Options
There are two different types of options that investors should be aware of, as they limit what you can do with your options:
- A call option gives you the right to buy the underlying asset
- A put option allows you to sell the underlying asset
In other words: the type of options contract you have entered into determines whether your option is for purchasing or selling.
As such, if you're holding call options ("long call"), you're hoping for the price of the underlying asset to go above the strike price (you're being "bullish") – once this happens, you can exercise your option and buy shares in the asset at the lower strike price, immediately selling them at the higher current share price to make a profit. Meanwhile, if you've bought put options, you're hoping for the price of the underlying asset to go below the strike price (being "bearish"). This allows you to sell your shares at the strike price, which is higher than the current value of the shares. If you're making a profit by exercising your options, the contract is said to be "in-the-money", while losing money by trading options or by letting the contract expire is called being "out-of-the-money" (OTM). You may also hear the term "at-the-money", which means a situation where the strike price is identical to the value of the shares.
When trading in options, you should also keep the break-even-point in mind: since you paid a premium for the right to buy shares in an asset at the strike price, selling immediately once the value of your shares surpasses the strike price may not be ideal, as you still have to earn back your premium. The break-even point is the point where buying or selling at the strike price gives you returns which outweigh the cost of buying the shares plus the premium.
Every options contract comes with an expiration date, which determines the last day you're allowed to exercise the option. There are also two types of options contracts that differ in terms of when you are allowed to exercise your options:
- American options: These options allow you to exercise your options at any point up to and including the expiration date
- European options: These options come with an "exercise date" – a precise date on which the options may be exercised. You can also exercise your options on the expiration date but not on any other day
Note that the person or organization offering the options contract chooses how the contract works, so they can determine which type of options they offer. Also, don't be fooled by the terms "American" and "European" – these refer more to traditional "styles" of options contracts. A European company may still offer American-style options and vice-versa.
Options contracts are a popular way of hedging your investments. For example, if you're already in long positions with a company's stock, you could buy put options against that same company. In other words: if the company does fine, you profit thanks to your long positions while only losing your premium for buying the options. If the company's stock drops, you have the option to sell your stocks at a potentially much higher strike price, which limits the overall amount of money you lose.
A combination of the following factors usually determines the premium of an investment option: share price, volatility (greater volatility increases the price), expiration date (the longer until the option expires, the more costly it is)
Meanwhile, you can potentially buy call options to make a more significant profit than if you invested in a company's stock right away. And since you only paid the premium to get the option of buying shares at the strike price, this limits your potential losses significantly compared to buying shares right away if the stock goes down.
Some popular options trading strategies include:
- Long call / long put: Buying or selling call options in the hopes that the stock price will go up
- Call spread: Buying a call option while simultaneously selling a call option with different strike prices on the same assets
- Straddle: Buying both call and put options on the same assets with the same strike price
- Strangle: Buying call and put options on the same assets with different strike prices
The CARL app provides you with unprecedented access to quantitative hedge funds with 15%+ targeted returns at only $20,000 minimum investment. Some of these may use options trading as a hedging strategy or even as their primary investment strategy – but what makes them unique is their quantitative approach to investing.
Quants use computer algorithms to determine the right time to exercise their options, potentially leading to maximum profit. What's more, their market analysis algorithms may allow them to predict future market movements with greater accuracy, which takes a lot of the risk out of options. After all, much of the risk of trading options lies in potentially making incorrect predictions about the future of the underlying assets. Historically, human fund managers have been more prone to make mistakes in this regard, while algorithms may be able to make much better calls if fed sufficient information.
Since quants often use computer simulations of the entire market environment, they can be fine-tuned to take into account information that a human hedge fund manager might simply overlook or erroneously consider irrelevant. That's the power of quants, and it's the main reason these types of hedge funds do particularly well when it comes to options trading. Open a CARL account today to find sophisticated options-based quants for your portfolio.