The stock market provides something for everybody, and a person with any level of investment experience can participate. While most new investors focus on stocks exclusively, there is more to the stock market than just investing in securities. Beyond the basic buying and selling of stock, options are a derivative of a stock that can provide investors with additional opportunities for hedging risk and generating extra income. In this article, investor Dan Calugar discusses some of the key terms as an introduction to options for those looking to expand their investment portfolio.
What is an option?
An option is a contract that gives an individual the right, but not the obligation, to buy or sell a particular stock at a predetermined price by a specific date. Options are usually written for each contract to be for the purchase or sale of 100 shares of that stock. Like purchasing an individual stock, investors can choose to invest based upon their belief that a stock price will increase or decrease. However, rather than investing directly in that company or stock, an option gives investors the ability to invest in a contract that allows them to make an array of choices with the underlying security.
What is a call?
A call is an option that gives an investor the right to buy a stock at a specific price. One popular example professionals often use is to compare a call option to a down payment on a home. Suppose a potential home buyer is interested in buying into a new community but is unsure how home prices will fluctuate. In that case, they might be interested in securing a down payment with a guarantee to purchase the home at a given price over the next three years. A homebuyer might give the developer $25,000 now with a guarantee to buy the home at $500,000. Even if the houses appreciate to $700,000, the buyer is guaranteed the purchase price of $500,000.
What is a put?
A put is an option that gives an investor the right to sell a stock at a specific price. In this scenario, buyers of puts are betting that the stock will drop below a certain point before the expiration. The premium is similar to the premium or deductible on an insurance policy, and in the event the stock price plummets, the investor can sell at the strike price rather than the market rate.
The strike price is the predetermined price at which the option holder can execute their right to buy or sell.
Options are traded with an expiration date. Option holders have the right to execute upon the contract on or before the expiration date if conditions are favorable. If they are not, they can allow the option to expire.
The premium is the price at which the option trades. As in the home purchase example, the premium would be the down payment of $25,000.
Why invest in an option?
Options give investors a multitude of advantages in comparison to investing in stock directly. One key benefit is that options require a smaller initial outlay of capital than purchasing a stock. Options also give investors a period of time to see how the market and price fluctuate. One way options protect investors is that they can reduce downside risk by guaranteeing a purchase price without obligating an investor to purchase. If market trends aren’t favorable, an investor can let the option expire without consequence and only lose the investment in the contract.
About Daniel Calugar
Daniel Calugar is a data-driven investor with an academic and professional background in computer science, business, and law. He developed a passion for investing as a result of frequent interactions with investment professionals who serviced the investment needs of his legal clients. As a tax partner at the Atlanta law firm of Hansell & Post and the global law firm of Jones Day, he incorporated his partnership interest allowing him to set up and serve as trustee for his own tax-qualified profit-sharing plan. Calugar utilized his technical skillset to design computer programs that would assist him in making more effective investment decisions. He then moved on to hedge fund investments before eventually focusing on more mortgage-backed securities, futures, and options after the stock market crash in 2008.
Dan Calugar has had the privilege to travel the world with his life companion in part due to the flexible nature of his work. He is into fitness and enjoys working out. He is a pilot with over 2000 hours of single-pilot experience flying business jets. He has been active with Angel Flight and has flown over 200 missions for Angel Flight West and Angel Flight Southeast over the past 15 years.