Become a better investor
Lesson in Course: Derivatives and options (beginner, 6min )
If we understand how options work, how and when should we use them?
Over the past few years, speculative investors broadly popularized YOLO (you only live once) bets or YOLO-folios (entire portfolios of YOLO bets). These bets often use high-risk options in hopes of earning huge returns while risking everything. Interestingly, the world's first YOLO option bet was between a Greek philosopher named Thales and olive presses in the 6th-century BC.
Thales had speculated that the olive harvest for the following year would be an exceptionally good one. So he sold all he had and placed a deposit on the local olive presses, which guaranteed him the use of the presses in the following year at a low rate. The bet paid off! When all the trees were burgeoning with olives at harvest the following year, Thales charged olive farmers a hefty premium to use the presses. How are options used today?
Options contracts are very versatile. They can be used to speculate, add leverage to a position, or lower the risk to an investor by hedging. Regardless of the use, investors like Thales decide to use options when they have an opinion on the future price of an asset. If we think the future price will go up, we would consider buying call options. If we think the future price will go down, we would consider buying put options. Let's cover each of these use cases.
Options are inherently speculative because contracts only exist for a short period of time.
We can hold a stock for a long period of time (assuming it does not become bankrupt or acquired) whereas an option can only trade for a set period of time before it expires. Options make it easy for us to essentially bet on what we think a stock price will do in the short term without having to own the underlying stock.
Here's an example of how we can speculate with a call option.
Speculating with options can be exciting and attractive since many brokerages have made it easy to do, the cost is relatively low compared to buying the stock, and the potential payout can be much greater than owning stock. While easy to start with, speculating is also easy to get wrong. In the case the stock price moves against our bet, our option can quickly become worthless and we've lost all of our money. A lot of people lose money speculating with options every year.
Adding options to existing stock positions creates leverage or an amplified effect on gains or losses.
A single options contract typically represents the right to buy or sell 100 shares of the underlying stock. So options provide us leverage because we can buy a single option contract for a fraction of what it would cost to actually buy all 100 shares.
This means options are a cheaper way to double down on an investment we like. Here's a quick example of how leverage can be created with options.
Using options for leverage is still speculative in nature, even if we use options for leverage on stock we already own. In the worst-case scenario here, if the options contract becomes worthless, we still own the shares and haven't lost all our money.
Instead of placing risky bets, we can use options to decrease risk, which is called hedging.
Using options to hedge is a lot like buying insurance against a drop in value of our current investments. We can buy put options that bet on negative price movements to offset our risk.
Let's walk through a quick example.
The profits we gain from put options make up for losses in our stock position if the stock price drops.
We can sell our options at any time and receive the premium a buyer is willing to pay to hold the option.
We can imagine that the townsfolk were eager to purchase back the rights to use the olive presses from Thales when they saw how many trees were flowering and bearing fruit. At that point, Thales had the opportunity to give up his rights to the presses to receive a lot more than his initial deposit. While Thales ended up holding onto his contract, we, on the other hand, could elect to cash in early by selling our options contract at any time. In practice, many investors and traders end up selling their contracts at times of profit or even at times of losses without exercising.
Selling the right to a contract can generate upfront income.
If we jump back to the beginning of the story, the townsfolk decided to sell the olive press contract to Thales to generate income on their presses. Thales had placed a deposit the year prior which became income for the townsfolk. Ultimately we know that Thales profited more than the townsfolk on that exchange; however, if the harvest was poor for the following year, the townsfolk would have generated good income for idle presses.
Before we start trading wildly, we need to decide how we want to use options. Out of all of the ways to trade, freely speculating is the riskiest. There's no downside protection, and any unexpected swing in price can result in big losses for us. Using options to leverage or hedge stocks that we already own are safer ways to get started.