In this article, we will discuss options and how to use them conservatively. We will use examples of how investors can use them to acquire shares in companies that they are looking to buy in a more conservative way than buying the stock directly from the market.
I like to compare options to what it would be like driving a Ferrari from New York to Los Angeles. It is possible to drive conservatively and have a safer and more comfortable ride than if you were driving a 1995 Toyota Corolla. Conversely it is also possible to drive a Ferrari at 200km and get to Los Angeles a lot faster but with a lot more risk.
A lot of investors do not understand the risks they are taking when they trade options. Often people think they are driving a Corolla when in fact they are driving a Ferrari. This involves many investors taking onboard significantly more risk than they are intending too when they trade. This leaves options gaining a bad name with investors and labelled as a risky investment.
While many options traders do drive their Ferraris recklessly, options can be used to acquire shares more conservatively than what they can be purchased for off the market.
A put option gives the owner (the buyer) of the option the right but not the obligation to sell an agreed number of shares on an agreed date.
A put option is a contract that is made with counter party that writes or sells the option. The buyer of the option pays the writer of the option a premium to own the option. Typically, the owner of a put option will benefit if the price of the underlying instrument increases in value while the writer of the option will benefit if the price stays the same or decreases. Put options are commonly used to hedge downside risk with a stock.
This is how options are traditionally used. An investor owns 100 shares of XZY at $10 per share. To protect their downside risk, they decide to buy a $9.50 put option. The cost (premium) of this option is $0.50 per share or $50 (100 shares X $0.50). This premium is paid to the writer of the option. There are a couple of days that this can play out:
Scenario 1: The stock price drops to say $5 per share. The investor has the right to sell his shares to the writer of the option for $9.50. As the investor purchased shares of XYZ at $10 his downside is limited because of his ability to sell at $9.50.
Scenario 2: The stock price goes up, stays flat or decreases to an amount that is higher than $9.50. In this situation the option is worthless. This is because the stock is trading at higher than $9.50. Why would an investor want to exercise his right to sell the stock at $9.50 if he can sell it to the market for more? In this instance the option expires worthless, the writer of the option receives the premium and the trade ends.
How to use Put Options to Buy Shares:
Let’s imagine an investor that wanted to buy 100 shares of the Commonwealth Bank of Australia (CBA.ASX) to hold long term. At the time of writing the last traded price of CBA was $78.99 per share. Let’s also imagine that this investor did not want to pay more than $76 per share. A 3.79% discount on its current trading price. This is the price that the investor feels are a good price to get into the stock to buy and hold at. The first choice for the investor would be to place a limit order at $76per share and leave it open. If CBA drops to $76or below, then the order is executed, and the investor buys 100 shares of CBA as he wanted to do. The second choice would be for the investor to write or sell 1 put option at $75 per share. This means that the investor is making the commitment to buy 100 shares of CBA from the buyer of the option if the stock is trading at below $75 when the option ends. The $76 options expire in one month (November 23rd2017) and the last traded price was$0.26per share. The buyer of the option pays our investor $26(0.26x100) for the option. This premium will vary from stock to stock depending on the stock's price, the time of the option and volatility.