What are Options in Stock Trading?

Several nights ago I was grocery shopping. After gathering everything I needed from my list I started approaching the front of the store so I could check out and pay for my groceries. Arriving at the front of the store there were two cashiers and lines available to be checked out from that were seemingly of equal length as far as a head-count goes. Just like any shopper approaching the same situation, you do your best and try to factor in any and all relevant information you can pick up on that will help you determine which line you should invest yourself into that would let you exit the store and get your groceries home faster.

Although both lines had the same amount of people, one line had a fast cashier and a high grocery-to-person ratio (each person had a lot of items), and the other line had a slow cashier and a low grocery-to-person ratio. During the milliseconds that this analysis was taking place I noticed someone approaching rapidly to get into a line and I therefore had to make my decision quickly despite the uncertainty of which line would be faster. I took the slow cashier and low grocery-to-person ratio line, and my competitor was forced into the fast cashier high grocery-to-person ratio line. Unfortunately my competitor was checked out several minutes before me and in situations like these it makes me very happy to know that you can protect yourself from this when stock trading by learning how to use a simple financial instrument known as the option.

What Are Options?

Despite the bad reputation derivatives as a whole have, options are a form of derivative that are based on creating a contract that allows you to either purchase or sell shares at an agreed upon price and within an agreed upon time. If you don’t activate your option, otherwise known as exercising the option, within the agreed upon time then the contract is voided. There are numerous reasons for using options, but they are often created and utilized as a way to protect against loss due to high uncertainty levels.

The way you attain a contract is by paying what is known as a premium up front to whomever is on the other side of the contract as consideration for their taking over the risk of whatever you’re trying to prepare for. If the option isn’t exercised then they get to keep the premium, but if you do exercise it then they have to fulfill their side of the contract, which could result in large losses for them. Nonetheless, they get the time-value advantage of investing the cash you gave them up front for entering into the contract.

How are Options used?

Imagine you’ve discovered a public biopharmaceutical company that you learned was in the final stages of FDA drug approval, and you’ve figured that the upside on their share price if they do get approval is tremendously more than what it’s currently selling for. Over the past several months the share price has been moving upward from a few cents per share to several dollars out of anticipation of FDA approval. You take your hard-earned money and decide to purchase some shares because you would like to make a small fortune on this supposed wonder-drug but you know that if this company doesn’t get approval there will be a large sell-off and the stock price will return to less than a dollar which would be nearly an absolute loss of your investment.

Put Option

To protect yourself in a situation like this you would purchase something known as a Put Option which gives you the right to sell your shares in the company at an agreed upon dollar amount which would help protect your investment if the company didn’t get FDA approval and the shares quickly returned to their initially low market price. As the shares declined in value, your put option contract’s value would sky-rocket, and you would have the right to either sell the contract or exercise it yourself to recoup your losses.

Call Option

Alternatively you could avoid the situation all together by purchasing a Call Option on the shares in the biopharmaceutical company. This type of option contract gives you the right, but not the obligation, to purchase shares in the company at an agreed upon price within a particular time. You just have to purchase the contract and only risk the amount of the premium you give up to buy the contract. If it turns out that the company does get FDA approval, and the shares sky-rocket, then you’re left with a very valuable contract which you can either sell or use to buy the shares in the company at the lower price.

Options are a great way to hedge your bet against the inevitable uncertainty that comes with all investments. Many of us don’t look at them as such but options can be considered a form of insurance against whatever exotic stock trading maneuver you’ve given yourself. There are many tools available for us to capitalize on uncertainty when investing, and hopefully one day there will be enough processing power and information tracking technology available so you won’t make the same mistake as I did in choosing which grocery line to stand in.

Photo by NobMouse