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Why use options?

You're familiar with the financial world and stocks no longer hold any secrets for you? You're ready to assume higher risk for higher gain? Options could be of interest to you. They can provide high returns if you understand how they work and can use them to your advantage.

The right to buy or sell

Like stocks and bonds, options are securities with strictly defined terms and properties.

An option 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.

Say for example you discover a house (underlying asset) you'd love to purchase but won't have the cash to buy it for another 3 months. You talk to the owner and negotiate a deal that gives you an option to buy the house in 3 months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000

In the next 3 months, 2 theoretical situations might arise.

Betting on the market value

  1. A celebrity falls in love with the house and insists on buying it. As a result, the market value of the house skyrockets to $1,000,000. Because the owner sold you the option, he's obligated to sell you the house for $200,000. In the end, your profit is $797,000 ($1,000,000 - $200,000 - $3,000). Not bad!
  2. A reporter doing research in the neighbourhood over the last 6 months discovers that the ghost of Henry VIII haunts the master bedroom and that a family of super-intelligent rats has built a fortress in the basement. Not really the house of your dreams after all. On the upside, because you bought an option, you're under no obligation to go through with the sale. Unfortunately, you still lose the $3,000 price of the option. Not easy on the wallet, but your peace of mind is worth it.

Options on financial markets

Options are called derivatives, meaning that an option derives its value from something else, called the underlying asset. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or group of stocks (stock market index). It can also be a currency or merchandise. There are 2 types of stocks.

Calls: A call gives you the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the price of the stock will increase before the option expires.

Puts: A put gives you the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Versatile securities

The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

You can be an options buyer or seller. If you're a buyer, you have the choice to exercise your right if you choose.

Sellers, however, may be obligated to buy or sell. The put market is more complicated and therefore can be even riskier.

Let's look at options from the point of view of the buyer. There are 2 main reasons why an investor would use options: to speculate and to hedge.

Speculation

If you buy an options contract, you're betting on the movement of the security.

This kind of bet requires extensive knowledge of financial markets and a high risk tolerance. Why? To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions too!

Buying options also allows you to use leverage. Leveraging allows you to pay only a small percentage of the share, $10 instead of $100, for example. Leveraging therefore allows you to make substantial profits with a minimum investment. If your predictions are accurate, you could double or triple your initial investment. If not, you could lose your initial investment entirely.

Options trading can be extremely risky.

Hedging

Think of it as using options as an insurance policy to protect your stocks against a downturn.

Why buy options if you're so unsure of your stock pick? This strategy can be useful to limit losses. It's used by large institutions who buy large blocks of options.

Even the individual investor can benefit. By using options, you would cost-effectively be able to restrict your downside while enjoying the full upside, as in the example below.

Let's say you buy 100 shares at $30, hoping they will go up soon. To hedge, you buy a put option at $1 a share, paying a total of $31 per share. The contract guarantees a selling price of $25 over the course of next 3 months. 2 hypothetical situations could occur during this period.

The stock price goes down. You limit your losses if the stock price drops to $15. Instead of losing $15 per share, you lose $6 (($30 +$1) - $25).

The stock price goes up. You make a profit if the share climbs to $40. Your profit is reduced by $1 a share because your put option is now worthless.

Options to attract employees

This is a third reason for using options. Many companies use stock options as a way to attract and keep talented employees,

These are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between 2 parties that are completely unrelated to the company.

Useful link

TMX - Montréal Exchange: see the Options FAQ.

Tools and tips

How options work

A fictional example to illustrate how options work.

Read tip - How options work

Types of options

Main exercise types and styles.

Read tip - Types of options

How to read an options table

What the columns in an options table stand for.

Read tip - How to read an options table

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