However, when you break it down, options aren’t really that much more complex than buying and selling shares in the usual fashion.
How do options work?
An option is really just a contract that gives you the choice, or the option, to buy or sell a security at a later date. Importantly though, this contract allows you to choose whether or not to go through with the transaction, meaning that if it wouldn’t be profitable for you to do so, you can choose not to.
For example, suppose that you predict that a company’s shares will go up next month. You could buy an option to buy those shares, in a month’s time, at their current price. If you predict correctly, and the price goes up, you can use your option to buy those shares for the lower previous cost, and then sell them on the market, generating a profit. If the shares don’t go up in value, then you can simply choose not to use your option, resulting in no further expense for you. Importantly, while you don’t transfer any of the underlying shares when you first enter into the contract or if you decide not to use it, you do actually end up directly owning the shares if you do use your option.
Of course, being able to lock in a future share price in this manner isn’t free, or it would be very difficult to find anyone willing to enter into an option with you. When you buy an option, you do so by paying the premium, usually set at some amount per share, with most options involving 100 shares. The premium is derived from the share price of the underlying share, making options a type of derivative.
The premium is how the option seller is looking to make their money. You want to buy the shares at a profit, meaning the seller has to sell to you at a loss. However, if you don’t use your option, they don’t have to sell you anything, and they get to keep the premium.
Why use options?
Options are very flexible, with a whole host of ways to structure and use them. In addition to buying shares in a single company, they can be tied to an index, giving you broader exposure. You can also have options to sell at a set price, a ‘put’ option, compared to an option to buy, or a ‘call’ option. These can provide a hedge against losses in the event of a downturn, or even help you make a profit by effectively shorting a stock.
What to be aware of before investing with options
An important consideration with options is the expiry date. All options have a date of expiration, at which point they must be used, or the contract becomes no longer valid. Some option contracts, called European options, can only be exercised on the expiration date, or not at all. More common though, are American options, which can be used at any point until the contract expires, providing greater flexibility.
Options are one way to protect or grow your wealth, but like other derivative types, they do have inherent risks. While your losses will be limited to the premium at most, this could still be a substantial amount of money depending on the value of the contract. Options can also be very complex, so make sure you understand what you are entering into and the potential losses you could make.
It is always best to conduct thorough research and read the PDS before making an investment decision.
Header image source: Solarseven/Shutterstock.com
This is an update of an article originally published by Tim Smith.
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