Turbulent Market? Try Options
The stock market’s future is unknowable. But amid periodic market jolts due to Europe and the like, you can buffer your portfolio from downturns or take advantage of possible price spurts. You employ a time-honored method that too few individual investors understand – options.
An option is a standardized contract to either buy or sell a stock at a pre-determined price on a specific date. Unlike simply buying and selling stocks, options present less risk because you don’t lose as much money if your intuition fails you.
What if you had had a hunch that Microsoft (MSFT) can potentially skyrocket when it introduces Windows Blue? Should you risk purchasing Microsoft stock on just a hunch? Or what if you owned 100 shares of Apple (AAPL) and want to protect yourself from the stock’s recent declines? You can do both through buying an options contract.
The key word is option. Should you buy some, you have the choice, not the obligation, to exercise your contract provided that it makes financial sense for you at that future date. That’s different from a futures contract, which obligates you to buy or sell even if it the trade doesn’t go in your favor.
Option trading, around for thousands of years, either protects the value of an existing investment or speculates on the future movement of an asset. There are two types of option contracts: calls and puts.
A call option allows you to buy a stock at a set price in the future, whereas a put option is a right to sell a stock at a set price up ahead.
Here are two examples to demonstrate how each works.
Put option. An investor buys a put option if she feels a stock is in decline and wants to lock-in a particular price. Let’s say it’s March and you own 100 shares of Apple that you bought for $400. You think that the price of Apple is sure to fall from its current price of $457 in the coming months, and you want to protect your gains.
Each option controls 100 shares of the underlying stock, so one put option gives you the protection you seek. You could buy a $450 put option that expires in May. If the price of Apple goes down to $375 between March and May, you can exercise your option and sell your shares at $450, $75 above market price. This is how an option can be more profitable in this case than simply selling the shares for $457. If the price of Apple rises above $450, you are daft to exercise the option, so you just keep your shares and let your option expire.
Call option. You buy a call option if you expect the price to rise. Continuing with our Apple example, assume you don’t own the stock, but you think that Apple stock is about to rise in the next couple of months. You could buy an option, expiring in May, that allows you to buy Apple stock at $500. If the price hits $550, you could exercise your call option and buy the stock at $500.
Then you can either hold or sell the shares at market price, pocketing $50 per share. Again, if Apple’s price does not rise by the May expiration date, you simply let your option expire and your only loss is the price of the option contract.
Obviously, you must subtract the contract’s price, known as a “premium,” from your gains. Recently, with Apple’s stock price at $409, the June call contract to buy Apple stock if it hits $425 was $9.55. You pay 100 times that, or $955, to cover 100 shares. The premium varies according to many factors, such as the time until the option’s expiration and the underlying stock’s volatility.
As you can imagine, options can be useful for certain investors who are interested in protecting a large gain, benefiting from a stock’s movement without actually owning the stock or diversifying. While only two types of options exist, an investor can employ a multitude of strategies by combining calls and puts.
This doesn’t mean that there is easy money in trading options. Only experienced investors who really understand market mechanics and how to use options effectively should use them. They can be quite complicated and can be rather risky.
Remember that the parties on both sides of every trade bet that the other is wrong. If a brokerage sells you a put option on Apple, they are betting that the stock is heading up, and they definitely have access to more top-level research than you. Some people brag about making a lot of money in options, but be careful because option prices move very rapidly. You can quickly make a lot of money, but you can also easily lose a lot of money in just a single day.
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Ara Oghoorian, CFP, CFA, is the founder and president of ACap Asset Management in Los Angeles, Calif. A fee-only investment management firm, it specializes in helping doctors and physicians make sound financial decisions. Contact Ara at firstname.lastname@example.org or on the Web at www.acapam.com
This article first appeared on the Financial Planning Association’s blog at http://blog.fpaforfinancialplanning.org/2013/04/18/how-do-options-work.
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