What are the odds? Many say options are risky, complex, and not my cup of tea. They are complex only because traders put in all sophisticated lingo and make the transaction look complex. It is like solving E=MC2 without learning 2×2. If you understand the very logic behind this financial instrument, everything will fall into place.
What Is So Difficult About Options?
When you invest in stocks, you analyze where the stock price will move. You base your expectation on things like the fundamentals, market, economy, and company’s management. But what makes options difficult is the time. You have to predict when the stock will move and where.
It is like having the precision of an eagle. When an eagle flies to catch a moving prey at the ground, it doesn’t fly to where the prey is, but where it expects the prey to be when it reaches the ground. Even the eagle misses the prey if its expectation goes wrong.
An options buyer is that eagle who predicts where the stock will be at a certain time. He accordingly buys a call (expecting the stock price will rise) or put (expecting the stock price will fall) option for a premium. To make that prediction, the buyer of the option looks at various things:
The direction in which the stock has been moving using technical charts
Any roadblocks or diversions ahead (in the form of earnings, product launch, or a macro event)
And the pace at which the stock is moving (by looking at the fundamentals)
But Options Need Not Be That Difficult
The options buyer makes the prediction, and the option seller bears the risk. The seller is willing to take the risk in return for a premium. But the seller won’t take the risk blindly. He does his prediction. But unlike option buyers, the options seller’s prediction is broader or vague.
It is like the option’s seller predicting the sun to shine in summer or predicting the storm to go in the direction where the winds flow. You do not expect sudden precipitation or snowfall in summer or the hurricane to change its course. The option seller earns a premium for hot summer days because the option’s buyer wants to hedge the risk of rain.
But how do you determine the premium for the option? Options are time-bound. They grow ripe as the time to maturity nears.
The Analogy Behind Options Premium
Have you ever booked a flight ticket in advance? The ticket gives you the option, not an obligation, to travel at a set date on a set time. If your date of departure is far, the ticket price is low. As the departure date nears, the ticket price increases depending on the demand and availability. If there is a change in your, you can miss the flight. All you will lose is the ticket price. The airline that sells the ticket is like an options seller and benefit from the ticket price.
This is just the ABC (Accelerator, Brake, and Clutch) of driving. The real challenge is how you use these controls. That will determine whether you become a Formula 1 race car driver or a regular rider.
There is an ocean of strategies and permutations and combinations you can use depending on the purpose of trade. I will take a real-world example to explain why do you even need an options contract in the first place.
A Real World Use of Options Contract
Sam has been saving for a house that will cost him $450,000. He is expecting a payment of $50,000 from a client in three months. Now, the house he wants to buy is at risk of being sold early. So Sam enters into a call option with the homeowner and gives the owner $4,000. Where did this $4,000 amount come from? This was the price that both Sam and the homeowner agreed for entering the contract.
Under the contract, the homeowner agrees to sell the house to Sam for $450,000 after three months, irrespective of the market conditions. This way Sam has hedged the risk of losing his dream house because he is falling short of $50,000, and he does not want to take a loan. Whether Sam buys or doesn’t buy the house, the homeowner gets the $4,000 premium for the call option he sold.
Scenarios Where You Wished You Had an Options Contract
In the above example, there can be two scenarios. Either the house price can go up or down. Depending on where the price goes, Sam will either exercise the option or let it pass.
Remember the hurricane we talked about earlier in the article. It hits the area and damages the underlying home, thereby reducing the house price to $400,000. Imagine if Sam had taken a loan and bought the house for $450,000, he would have to bear the repair cost ($50,000) too, bringing the total cost to $500,000. The call option saved Sam. Now he can just let the option expire and buy the house for $400,000, and do the repairs if he wants to. He transferred this loss to the homeowner for a $4,000 premium.
Sam has a lucky day. A famous movie star buys a house in the neighborhood. Suddenly the neighborhood is in demand, and the house prices shoot up to $500,000. The homeowner cannot do anything as he is under obligation to sell the house to Sam. Sam can either exercise the call option and buy the house for $450,000 or sell his option at a higher premium to another person. The choice is with Sam.
But the above scenarios are one-off and the probability of them occurring is very low. The homeowner sells the call option thinking that nothing out of ordinary will happen in three months, and he can earn an extra $4,000. Most times, it is the option’s writer that walks away with a premium without doing anything. But if the luck is on Sam’s side, the homeowner has a lot to lose.
Eagle Or The Homeowner
Many people come to the options market to bet, hedge, or speculate. Whether you want to be the eagle or the homeowner, the option is yours.