Options & Derivatives
First, a note of caution – options and derivatives investing is very risk and requires a lot of education and nerves of steel. We would highly recommend working with a Financial Professional <Click Here to get a recommendation> if you are interested in these types of investments.
First, let’s define what we are talking about:
Options: An option, as the name implies, is the right, but not the obligation to buy something. As an easy example, several airlines including United Airlines offer customers a chance to “lock in” the price of an upcoming flight if they are not ready to purchase yet. They call their service “FareLock” and for a small charge you can lock in the price of a flight. If the price goes down you can ignore the lock and just buy at the lower price. But if the price goes up, you can use the locked in price and save money over what it would have been. If you’ve ever used a service like Farelock, congratulations, you’ve bought an option.
There is even a company that has sprung up to allow you to lock in the price on any airline (buy and option). It’s called Options Away (www.optionsaway.com) and it provides services to Orbitz and Kayak, among others.
So, getting back to options from an investing perspective, if you were to buy an option on an equity, you would also have the right, but not the obligation to purchase that equity at a particular price. Options are often used as a hedge when an investor holds a large position in an asset. For example, if you own a lot of Bell Canada and are worried that the price might go down, you might buy an option to sell the stock at a certain price near the price you paid for it (called a “put” option, the right to buy an asset is called a “call” option). That way if the price of Bell Canada goes up, you’ve wasted money on the put option, which serves as a kind of insurance. But if Bell Canada goes down, you can use your put option to sell the stock at a price near to what you paid for it, avoiding large losses.
Of course, since options are relatively inexpensive compared to the underlying stocks, buying options is often a strategy when the investor wants to make a high risk/high return bet on an equity or commodity. For example, let’s say the investor thinks the price of oil is going to rise very soon and they want to capitalize on that by buying some shares in an oil company (there are other ways to make this investment too such as buying a mutual fund, an oil index or even barrels of oil). Now let’s assume they have $10,000 to spend and the current price of the equity in question is $100/share. Let’s look at their options.
Option 1: Buy the shares
They would take their $10,000 and buy 100 shares of the oil company.
Option 2: Buy an option
It is possible to buy options for the current price ($100) and for prices higher or lower than this price for various periods in the future – days, weeks, months or even years. The price of the option will depend on the relative risk to the issuer of the option. If you are asking for a price that is under the current market price and expecting to hold that price for a year, the cost of the option will be very high – the reverse is true.
Let’s say our investor decides that the market is going to move very quickly and buys an option to buy (call) at the current price ($100) for one week. She may up spending less than $1 for that option – but to make our math easier, let’s say she had to spend $1/share. So, she buys 10,000 options.
Let’s see what happens to our investor in several scenarios after a week.
Scenario 1: Stock goes up to $110/share.
Option 1: Our investor sells at $110/share and pockets $1,000, less transaction fees.
Option 2: Our investor uses the call option to buy and then sell the 10,000 shares for a total return of $100,000 – 100X what she would have made by buying the stock alone (even though she only had $10,000 to spend there are ways to monetize this transaction without having the money to do the buy and the sell – she could sell the option or get margin (credit) from her financial institution).
Scenario 2: Stock stays steady
Option 1: Our investor breaks even (less transaction fees of course)
Option 2: The option becomes worthless and our investor loses all of the $10,000 invested.
Scenario 3: Stock drops to $90/share
Option 1: Our investor sells at $90/share and takes a loss of $1,000, the opposite of what happened when the stock went up.
Option 2: Again, the option purchased becomes useless (why buy at $100/share when the stock is now $90/share) and the investor loses their entire investment of $10,000.
This simple example highlights the pros and cons of options. On the pro side, an option allows an investor to make a very big bet with a very small amount of money. But of course, the price is the potential downside risk. When our investor buys the underlying stock, their maximum loss in our example was 10% of the investment – this was also the maximum gain in our example. In the options example, both the upside and downside are magnified. The upside return is 10X the investment, but the investor must be prepared to lose the entire investment if they’ve bet wrong.
Options are not for the faint of heart.
Derivative: We covered options first because options are a common form of a derivative. Essentially a derivative is a financial instrument that gets its value from an underlying asset. So, in our example above, the option value is derived from the underlying value of the oil stock. There are lots of other forms of derivatives such as futures contracts (contract to buy an asset, such as corn, at a specific price at a future date), swaps (two parties agree to exchange a series of cash flows for a certain amount of time) and forward contracts (agreement to trade an asset, often currencies, at a future time and date for a specified price). Forward contracts are like options in that investors are making a bet on the movement of the underlying asset. But forward contracts make a commitment to make that trade.
During the latest financial crisis, you probably heard a lot about derivatives – like mortgage back securities. Since, by design, they tend to go up and down very rapidly, it is not hard to see that when things started to go bad in the market, investors started losing money very quickly.
Professional advice is highly recommended in this space (Click here to get a recommendation).