Options are a type of derivative. Derivatives are a group of investments that “derive” their value from an underlying security or rate. They are somewhat like a “bet” — between two investors trying to figure out which way an investment will move.
In simple terms, here is why an option is attractive. Say if you were to own a share worth $100. The share price of $100 increases to $105, and you profit $5 or 5%. If you own an option, however, you only need to pay a fraction of the initial share price but still can reap the entire $5. It is the ability to make more with less initial investment, but it is incredibly risky. Options trading should not be taken lightly, and for a first-timer, it can be incredibly intimidating. We advise that you do not start with options if you are new to trading!
When you buy an option, you are not purchasing the security itself; you are buying a contract that says you have the right to buy or sell a security at a certain strike price before a certain date. One option equates to 100 shares, and there are two types of options: call and put.
Pretend you are looking at the stock of Netflix, which is selling at $100. You have firm belief that the share price of Netflix will increase in the near future. You want to buy 100 shares of their stock, but you are concerned about the initial capital requirement it takes. There’s another investor, however, who believes that the stock price will not increase and already owns these 100 shares. You propose a call option, allowing you the right to buy Netflix’s stock if it hits a certain strike price, say $105, by a certain time window, or expiration date. You put down an option premium to purchase the contract, which factors the stock’s value, time until the expiration date, and potential volatility.
If your instincts are right and Netflix is now trading at $110, you have the right to buy Netflix’s stock at $105 for each share, then sell at market value of $110. You can now make a profit of $500, not including commission. The contract is now worth $500, and you can also sell the contract for profit by taking the contract value and taking away the premium you initially paid.
If this goes the other way and Netflix sells for $95 on the last trading day before the expiration date, then your option contract is deemed worthless and you lose out on the entire premium you put down for the seller. The seller now collects the entire profit, though the value of their securities did depreciate.
Let’s continue with our example of Netflix. You are now the seller of this contract, and this time you own the 100 shares, still trading at $100. If you project that the share price will decrease, you propose a put option to sell your shares at a strike price at $95. If the price of the share decreases to $90, you still have the right to sell the buyer your put option at the initial strike price of $95, turning in a profit of $500. This means that it is more profitable for the share price to decrease!