Options are contracts that give one party the right to trade a stock (or any other tradable asset) with the other party at a predetermined price. Here the option buyer (first party) has a right to trade at that price but has no obligation to trade. For instance, I could buy an option that will let me sell Woolworths stocks at $32/stock to an option seller, if Woolworths stocks fall below $32. However, if Woolworths stock goes above $32 I’m under no obligation to sell the stock to the seller.
This looks like ‘heads I win, tails you lose’. So, what is the catch? The catch is that, the option buyer pays a certain premium to the option seller. In this case I could be paying a premium of $2/stock for letting me have that privilege. If the stock doesn’t go down in the specified contract period, then the seller gets to pockets the premium. Think of something like a life insurance policy.
Let us play with an example. Adam, Angela, Mike and Marie are looking to trade Wesfarmers‘ stock during the earnings season. Adam thinks Wesfarmers is going to shoot through the roof with its new store pricing initiative. Angela has plenty of Wesfarmers stocks in her portfolio and believes Wesfarmers might not move up a lot. Mike is very sceptical of the stock and thinks it is going down and Marie thinks Wesfarmers is a good enough stock and will hold its position.
Now, Adam and Angela can trade a call or a call option where Adam has the right to buy the Wesfarmers stock at $198 in the next 2 months while Angela gets a premium of $10/stock for giving the privilege. Since, Adam thinks the stock is going above $210 he got a good deal and since Angela doesn’t think much of the stock she can get a rent of $10 for each stock in her portfolio.
In the same way, Marie can sell a put or a put option to Mike since she doesn’t think the stock would go down and while Mike got the insurance if Wesfarmers goes down due to bad earnings.
Why options make sense for each party?
For Adam and Mike, they get to play the bull or bear by just paying $10/stock, without having to put the full $197 (the stock price). If the stock goes to $300, Adam gets to multiply his money by 10 times (buy the stock from Angela at $197 and sell it for $300, making $103 profit – while investing only $10). In the same way, Mike could play the bear without shorting the stock. Thus, if the stock goes down to $100, Mike has made 10 times his investment (buy the stock from market for $100 and sell it to Marie at $197).
What are Marie and Angela gaining? If the stock doesn’t move a lot, both of them get to keep the premiums ($10 or more than 5% of the stock price) and they could do this month after month – making far more returns than just holding the stock.
Pros & Cons
Thus, the main attraction of the options is that it opens a wide variety of strategies. You don’t need to just buy and sell, but predict how big the movement will be and when the movement would occur. If done well, options can either dramatically cut down the risk or improve your profits significantly.
However, options are a doubled-edged sword and can easily cut your hands if you are not playing careful. If Wesfarmers stayed flat Adam and Mike would lose all their investment (premium), while they would not have lost anything had they just bought the Wesfarmers stock. In the same way, if Wesfarmers starts wobbling and got volatile, Angela and Marie get to lose a lot.