Options - Part 1

I thought I’d start the year with an application post that some of you might find useful. If you invest in the stock market, having a basic understanding of options can provide a lot of information about any stock.

Many of my friends think options are risky. This is incorrect if you understand options. Options allow you to actually shape investment risk according to your preference. Options are basically stock price insurance. When you buy insurance, do you think you are increasing your risk or decreasing it? You can choose your deductible when you buy insurance, and you can do the same with options.

In this series, we will develop a fundamental understanding of options and how to use them. Even if you do not trade options, they let you understand what the market thinks about a stock. If your beliefs differ from the market, you potentially have a profitable trade, provided your beliefs turn out to be correct.

There are two basic kinds of options related to a stock: Call and Put. Their prices relative to the stock price provide a wealth of information. Technically, Call and Put are different instruments, but they can offer similar insurance. Let me define them in the context of applications.

Suppose a stock is worth $100. You believe it will go up tremendously in a year, but you are also afraid it might go down. So you want to buy the stock for its tremendous upside but also want to insure against the falling price for a year. So you buy the stock and also buy insurance so that if the stock goes below $100, you still have the right to sell at $100. This is called a Put option.

When you buy a Put option, you have the right to sell the stock at a predetermined price during a predetermined time interval. The predetermined price is called the strike price, and the end of the predetermined interval is called the expiry. You pay an option premium, let’s say $5 for the year for the insurance. This way, your loss is now bounded by $5.

If you think of a falling price as a car accident, then buying the insurance limits your losses to the insurance premium you paid. But you can lower your insurance premium by choosing a deductible. You could do the same here. Let’s say you can bear a loss of $10. In that case, you buy a Put option at a strike price of $90. The premium may be significantly lower, e.g., $2.

So if you think of stock as your car, then a Put option is basically your car insurance, with the difference that you have to pay your entire premium upfront rather than in monthly installments. Just like with your car insurance, with options, you can choose your deductible and the expiry. Of course, the higher the deductible, the lower the premium. The longer the expiry you choose, the more total insurance premium you will pay, but less per month. Further, the more expensive the car is, the higher the premium you will pay. Obviously, you pay more premium for a $500 stock than for insuring a $100 stock. Additionally, the less safe the car is, the more insurance premium you will pay. The same applies to options. If the market believes the underlying stock is likely to crash, your option premium will be higher.

None of the above statements is due to some kind of economy of scale. If you think about it, it all makes sense since whenever the insurer takes on higher risk, the premium is higher. Only one of the above statements is somewhat tricky, i.e., the longer the duration of the insurance, the lower the premium per month. The reason is that the options cover only one accident. Once you use the option, also called “exercising it,” you get your money, but the option ceases to exist, unlike your car insurance, which continues to cover you for future accidents. Therefore, typically, but not always, options are exercised just before expiry.

There is a chance that a stock crash in the first month gets recovered on its own the next month, so the insurer does not have to compensate you. The mutual cancellation of stock price movements over time reduces the insurer’s risk, therefore the premium is lower. So the option premium for 2 months is higher than 1 month, but substantially lower than twice that amount.

Note that, as a practical matter, options typically deal with a bundle of 100 shares, but for brevity, we will think as if you can buy an option for 1 share.

To be continued in future, therefore feel free to follow the series.