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Our introductory investment guides are walking you through the largest trading markets in the world, from stocks to bonds to forex trading, and all the smaller markets that act as a binding glue to the major markets you see talked about on TV every day. Today’s review steps up the complexity a bit as we look at the world of trading stock options. Stock options are our initial foray into investment products known as “derivatives”.
If we take a step back and do a thorough definition of derivatives, we’ll also come to a well-rounded definition of what stock options are, and how they are used. Derivatives are securities that derive their value from another, different security.
Are Stock Options Derivatives?
Stock options are derivatives, in that an individual option contract derives its value from a specific stock. The specific stock in each case is called the “underlying”.
Futures contracts are also derivatives – they derive their value from a specific underlying price index or spot markets, such as those for oil, cattle, corn, or the S&P 500 index.
Then there are more obscure derivatives like forward contracts and swaps. Forwards and swaps are rarely touched outside of large banks and financial institutions. However, you may have heard Ryan Gosling talking about them in ‘The Big Short’.
A Deep Dive: Stock Options
The most important thing to know about all derivatives is that they have no inherent value. Investors call this type of value intrinsic value. Individual stocks have intrinsic value; as we learned in the introduction to stocks, common shares represent a claim on a company’s future earnings. Bonds have intrinsic value in the form of a principal repayment when the bond reaches maturity. Real estate has the intrinsic value of the land itself.
But derivatives have no intrinsic value. They are securities created for short-term usage, and they all have expiration dates. This means, well, what it sounds like. A derivative is designed with a finite, specific lifespan, which could be anywhere from a few days to a few years in the future. But it still has a lifespan – and if the conditions for profit are not met before that expiration, the contract disappears into a mist of zero value.
Now that we’ve covered what derivatives don’t have to offer let’s talk about what they do. They can be used to gain a lot of financial leverage. But like a knife or fire, they can be utterly dangerous if not handled properly. This is why Warren Buffett has called derivatives “weapons of financial mass destruction”.
Swaps, for instance, a thing most people have never heard of, played a huge role in the housing meltdown that spawned the Great Financial Crisis of 2007-2009. They almost took down the whole U.S. economy, the quiet swaps you’d never heard of. Today, all of the derivatives investors have access to are regulated by agencies such as the Commodity Futures Trading Commission (CFTC) for futures, the Options Clearing Corp (OCC) for options, and the Securities Exchange Commission (SEC) which is perched above all financial markets in the United States. Having strong regulators does not mean there’s no risk – there can be plenty – but it does ensure that the terms of each derivatives contract are standardized. Payments will always settle according to predetermined guidelines.
Why Do Financial Derivatives Exist?
Now you may be asking yourself, “Why is there a need for derivatives? Why not just buy the underlying financial asset if you want to?” It’s the right question to be asking, as the answer will help level us up on some critical understandings about derivatives.
In our discussion of forex, we talked about how large companies use foreign exchange markets to hedge against adverse outcomes. We live in an unpredictable world. And unpredictability can be very costly. If a company, farm, or an individual wants to protect against something, it is nice to have the option to do so (notice the subtle wordplay there; stock options are named thusly for a reason).
Derivatives exist primarily to allow one interested party to make a hedge – they are financial insurance policies. As with forex, most daily activity in derivatives markets is by people looking to hedge or mitigate risk. A cattle rancher worried about the price of cattle dropping just as he takes his herd to market is willing to pay a modest cost to lock in today’s prices. Cattle futures allow our rancher to do that.
Outside of hedging, there are large pockets of investors who use derivatives contracts to speculate on things. Most investors who want to trade the price of gold or silver don’t want to deliver the big heavy bars of metal. And they certainly don’t want to lug it around in a car to drive to a place where they can sell it later. Instead, most investors just trade futures contracts for gold and silver, without ever touching the real product. This ease of access and convenience appeal to large trading desks, institutional investors, and advanced traders.
Why Stock Options Exist
So, what about stock options? What roles do they serve the people who buy and sell them? First, recall that all derivatives are created with limited lifespans. Created, on an ongoing basis, month after month. You see, every financial transaction has a buyer and a seller. The two sides, known as counter parties, must exist for each trade to occur. Can’t have a sale without a buyer, can’t have a buy without a seller, right?
So, what happens when a stock option is “created”? It means that one party sells a newly written contract, written out of thin air by the initial seller. And another party buys that contract, fresh off the printing press. And for however long that contract, that specific stock option is in force, the initial buyer can sell it on the open market, or hold on to it, just like with shares of stock itself. That contract has a daily price, or quote, determined by market forces. But that is where the similarities between stock options and common stock come to an end.
How to Read a Stock Option’s Quote
It’s important to demystify how stock options trade and what all the terms on an individual contract apply to. So, let’s go through an example, with some graphic assistance from Yahoo Finance. Below is a screenshot of the intraday trading that was going on in one specific options contract for a particular stock, that stock being Netflix (NASDAQ: NFLX):
Let’s start with the very top, as the contract’s description gives us a ton of information:
NFLX July2020 475.000 call
Yes, that whole spiel is just the name of this contract! The way this is read is, “Netflix July 2020 $475 call”. Now let us break down each part of the name:
NFLX – the ticker symbol of the underlying stock. Remember, each option contract is for one stock and one stock only. Amazon, Nike, IBM, all those stocks have their own options contracts.
July 2020 – this is the expiration month of the contract. On the right-side column, you can see the exact “Expire Date” of July 31.
475.000 call – This is what is known as the Strike Price of the option, a vital feature. Arguably, the most important data point for trading options. The strike price is the price at which the holder of this contract (whoever bought it from the original seller/writer or bought it later on the open market) can choose to buy the underlying stock, Netflix. Now we are circling back to the naming convention in the first place, the “option”.
So, the picture is becoming more clear. We have a contract with the terms that state, “Up until July 31, 2020, the holder of this contract is allowed to buy NFLX shares for $475 precisely, no matter what NFLX shares are trading for on the open market”.
If NFLX common stock has been rising over the past several weeks, and now trades for $515 per share, the holder of this contract can choose to exercise it, which basically means to put the contract into force. The holder would contact their broker, tell them they want to exercise, and they can immediately spend $475 per share to obtain a stock that’s already worth ($515 – $475 = $40 more per share on the open market).
How Stock Options Work: Calls vs. Puts
There are two different classes of stock options – calls and puts. They exist as polar opposites. Our NFLX example above was a call contract – calls give the holder the option to buy something. Put contracts, meanwhile, provide the holder the option to sell something. Investors trading call contracts are making some variant of a bet that the price of the stock is going higher (as you’d only want to exercise the NFLX $475 calls above if NFLX stock was trading above $475, right?)
Meanwhile, in the world of put option trading, investors are making some variant of a bet that the price of the stock is going lower. Depending on someone’s existing exposure to a specific company, industry, or even a competitor, they may want to hedge or speculate on the price of a stock. This is why options exist – to give investors maximum flexibility while utilizing leverage.
Do you see the leverage involved here? Remember, leverage is all about you exchanging an upfront, modest amount of cash to control a much larger amount of investment capital somewhere else. Here in the options market, the leverage comes prepackaged in the contract itself.
Simple Math Behind Trading Options
Look back at the quote for the NFLX call contract:
That 11.63 is the market quote – the current price – of this call contract. That is $11.63, per share of Netflix. But each single options contract represents the buying power, the option to buy, 100 shares, not one share. And so, the cost to buy just one of these option contracts is:
$11.63 * 100 = $1,163
And while that is no small sum of money, consider how much it would cost the same buyer to purchase 100 shares of NFLX stock on the open market. Netflix closed recently at $485.80/share. So, 100 shares would cost $48,580!
In the case of this call option, the buyer is getting immense leverage, able to earn the gains on nearly $50,000 of stock for less than $1200.
How Do Investors Use Options?
Stock options are the swiss army knife of investing – they can be used to accomplish many tasks in many ways. There are volumes upon volumes of resources and books that go into detail about various strategies for trading options. For the time being, consider these typical use cases for options:
1. Initial sellers/writers of options
Typically looking to lock in gains on large stock positions they already own. Just like the cattle rancher, they want to lock in a price now in case the stock were to tank in the near future.
2. Patiently wading into a large stock position
Imagine you are a mutual fund considering buying a large block of shares in each company. Rather than having to commit all that cash up front, you can buy some call options instead, spend a fraction of the money, and if the stock rises, you haven’t missed out on the gains. And if the stock goes lower instead, you are only out what you paid for the call option itself.
3. Speculating on rising/falling stock
Maybe there is a big event like an earnings report coming. An investor can make a speculative bet for either a sharply higher or lower stock price following the earnings report. If they’re wrong, they’re out a smaller amount of capital than if they’d bought a massive chunk of shares or tried to short common shares.
Wrapping Up: Beginners Guide to Stock Options
You are not wrong if your brain is spinning. These are complex topics, especially for newcomers. There is a good reason why over 30% of the entire multi-year preparation for the Chartered Financial Analyst (CFA) exams deals with derivatives contracts.
Stock options are intricate. We are just beginning to scratch this surface of what can be done with options with our introduction and discussion of one Netflix call option.
Our hope is to inspire those who find themselves eager to learn more, those seeking to trade derivatives in the future and looking to add tools to their investing arsenal. There are many useful educational resources and trusted partners out there to assist you on your journey. And when used properly, stock options can actually be used to lower overall risk to a portfolio, despite the massive leverage involved. This is why they’re a popular tool for hedge funds, institutional investors, and other high-net-worth investors.