We all have options in life, and we make decisions, some sound, some not so. When it comes to investing, there are you should think about options investing, which actually has a completely different meaning to what you’re used to.
Adding options to your portfolio of stocks, bonds and other investments can be a great idea if you understand the details of what you are investing in. That is not to say that it can be overly complicated.
By understanding the fundamentals of options investing, you will be better prepared to manage a portfolio of mixed investments – with lower risk and generating higher returns on your money.
Derivatives – What are futures, forwards and options?
There are a group of financial contracts called derivatives. Derivatives have been in the news a lot more since the global financial crisis – some bankers used these contracts in the wrong way and lost a lot of money. However do not let this put you off – investors, both small and large, have been using options for decades and making money as part of a carefully managed portfolio and investment plan.
The three main types of derivatives are futures, forwards and options. Derivatives contracts are called that because they derive their value from another underlying asset. A futures contract is nothing to be scared of – it is simply an agreement to buy or sell, in the future, a specific quantity of an asset at a specific price. A forward is the same thing apart from in the case of future your contract is listed on a regulated exchange and with a forward your contract can be with any counterparty. An option is also a type of derivative.
What is an option?
If you buy an option, you have a contract that gives you the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is security – just like a stock or bond.
How does it work?
If this seems confusing, consider this analogy:
You see a car that you’d love to buy. Unfortunately, you don’t have the money to buy it for another two months. You talk to the seller and negotiate a deal that gives you an option to buy the car in two months for a price of $10,000. The seller agrees, however for this option, you have to pay a price of $300.
During the two months, you might find out that this car used to belong to a famous movie star – so after you buy the car in two months you can sell it on for over $100,000. In this case, you make a profit of $89700.
However, it might be the case that during those two months you find out that the car is known to be slow to start. In which case you change your mind and decide not to buy the car – so you are out of pocket only $30 rather than the full price.
This example demonstrates that when you buy an option, you have a right but not an obligation to fulfil the contract – you have the choice to let the expiration date go by, and the option becomes worthless. If this is the case, you lose 100% of your upfront investment.
You can also see from this example that an option is all about the underlying asset – that is why they are called derivatives. In this example, the car is the underlying asset however when it comes to investments the underlying asset could be a bond, commodity, currency pair, stock or stock index.
How is it used?
The two types of options are called calls and puts:
- Calls give you the right to buy an asset at a specific price within a specific period of time and most buyers of calls hope that the underlying asset price will increase substantially before the option expires so that you can make a profit.
Like in the example, you would want the value of the car to go up since you have already locked in the price at which you would buy at. So if you have an opinion that a particular asset is going to go up in price it can be a good idea to buy a call option on that asset, as long the upfront price of the option (called the premium) is not too high for it to be worth your while.
- Puts give you right to sell an underlying asset at a specific price within a specific period. Buyers of puts hope the opposite of the above – you would want the price of the underlying asset to fall before the option expires as you have locked in a better price for you to sell at in advance. So if you have an opinion that a particular asset is going to go down in price it can be a good idea to buy a put option on that asset, as long the upfront price of the option (called the premium) is not too high for it to be worth your while.
Main uses: Opinion and Protection
Investors use options both to speculate and hedge risk. The examples above for calls and puts show speculative use for options investing – the investment is based on an opinion or view of the market.
However, an alternative use it to “hedge”. This is a fancy way of saying you want to protect or insure part of your portfolio. As an example, if you bought Coca-Cola stock at $35 and did not want to have to sell below $35 if the share price falls you can buy a put option. If you select a put option that gives you the option of selling your share at $36, but the option itself costs will cost you $1, it is still worth your while as you will have protection from downturns in the Coca-Cola share price.
Which asset classes?
As it is a derivative contract you can buy options for almost every asset class – stocks, bonds, forex, indices and much more – as long as you can find someone willing to sell the option to you. Each option contract has its specific details so you should check the specific terms before investing.
Is investing in options too risky?
Investing in options is very versatile and can be as speculative or as conservative as you prefer. Options can be quite complex in some cases and can be very risky. This is especially true for speculative investing. This might not be your style, but that doesn’t mean options aren’t right for your portfolio. You could use them for hedging and diversification.
Make sure you understand options before you put any money in. Many businesses, banks, individual and commercial investors use options because when used carefully that can bring many benefits to your investments. There are risks involved – and by taking some time to understand the details you can harness the power and benefits of options investing in working to your advantage rather than letting the risks work against you.
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