STOCK OPTIONS 101: BASICS AND KEY INVESTMENT RISKS

What Are Stock Options?

Stock options are financial instruments that give investors the right, but not the obligation, to buy or sell an underlying stock at a predetermined price on or before a specific date. They are commonly used for hedging, speculation, and strategic portfolio management. Options are categorised primarily into two types: call options and put options.

Call Options

A call option provides the holder with the right to buy a stock at a specified price, known as the strike price, before or on the expiration date. Investors use call options when they anticipate a rise in the stock’s value.

Put Options

A put option grants the holder the right to sell a stock at the strike price within a defined time frame. Investors purchase put options when they expect the stock’s price to decline.

Option Contracts

Options are sold in lots called contracts, with each contract typically representing 100 shares of the underlying stock. The price paid for an option is called the premium and is influenced by various factors including the stock’s volatility, time until expiration, and how far the current price is from the strike price.

Expiration Date

This is the last day on which the option can be exercised. After expiration, the option becomes worthless if not exercised. Expiration cycles may be weekly, monthly, or quarterly, depending on the instrument and exchange.

In-the-Money vs. Out-of-the-Money

• In-the-money (ITM): A call option is ITM when the stock price is above the strike price; a put is ITM when the stock price is below the strike.
• Out-of-the-money (OTM): A call is OTM when the stock price is below the strike; a put is OTM when the stock is above the strike.

Common Uses of Stock Options

• Hedging: Mitigating potential losses on stock holdings.
• Speculation: Profiting from short-term price fluctuations.
• Income Generation: Selling options to collect premium income.

Understanding these fundamental concepts is essential for anyone considering using stock options as part of their financial strategy. While they offer flexibility and leverage, they also carry unique complexities requiring careful consideration.

How Stock Options Work in Practice

To fully comprehend stock options, it is useful to see how they function in various scenarios. From executing strategies to measuring profits and losses, trading options requires familiarity with both conceptual and operational principles. Here is a breakdown of how options are typically used and assessed.

Example of a Call Option Strategy

Imagine an investor believes that XYZ Corporation's stock, currently trading at £50, will rise in the coming months. The investor buys a call option with a strike price of £55, expiring in two months, for a premium of £2 per share or £200 per contract (since each contract covers 100 shares).

• If the stock rises to £65 before expiry, the intrinsic value of the option is £10 (£65 - £55). Subtracting the £2 premium, the net gain is £8 per share or £800 total.
• If the stock stays below £55, the option will expire worthless, resulting in a £200 loss (the premium paid).

Example of a Put Option Strategy

Conversely, consider an investor predicting a downturn in the market. They purchase a put option on ABC Ltd., currently trading at £40, with a strike price of £35 for a £1.50 per share premium.

• If the stock drops to £30, the put becomes worth £5 (£35 - £30). After deducting the premium, the gain is £3.50 per share or £350 total.
• If the stock remains above £35, the option expires worthless, and the investor loses the £150 premium.

Option Greeks

Successful option trading often involves understanding the “Greeks”, which are metrics that measure risk and potential price movement:

• Delta: Sensitivity of an option’s price to the underlying stock price.
• Theta: Time decay of an option as it approaches expiration.
• Gamma: Rate of change of delta over time.
• Vega: Sensitivity to volatility of the underlying stock.

Assignment and Exercise

If an investor exercises a call option, they will purchase the stock at the strike price. Options sellers, particularly those writing covered calls or cash-secured puts, may be assigned to fulfil the contract. It’s vital to be prepared for assignment, especially near expiration.

Commissions and Fees

Options trading typically involves brokerage commissions and fees, which can vary based on the platform. Frequent trading or complex strategies might incur additional costs that affect returns.

Tax Considerations

Tax rules concerning options can be complicated and vary by jurisdiction. In general, profits from option trading are considered capital gains or losses for tax purposes, but certain option strategies may invoke different tax implications. Investors should consult a certified tax adviser or accountant familiar with options trading.

By reviewing detailed examples and understanding the mechanics, investors can better appreciate how options operate in real-world contexts and what considerations to make when buying or selling options.

Risks and Considerations of Options

While stock options offer considerable opportunities for strategic investing and potential gains, they also come with significant risks. It's crucial for investors to understand the numerous ways in which options trading can lead to losses or complications, especially for inexperienced market participants.

High Leverage Risk

Options provide exposure to high levels of leverage. With a relatively small capital outlay (the premium), investors can control large amounts of stock. This magnifies both potential gains and losses. An unfavourable move in the underlying asset can result in losing the entire premium invested.

Time Decay (Theta Risk)

Options are depreciating assets. The closer the option gets to its expiration date, the more value it loses due to time decay. Even if the stock moves favourably, an option might lose value if the movement occurs too late.

Volatility Risk

Changes in market volatility significantly impact option premiums. An increase in volatility tends to inflate option prices, while decreased volatility deflates premiums. Traders relying on volatility for profit, such as in straddle or strangle strategies, may suffer losses if volatility contracts unexpectedly.

Lack of Liquidity

Thinly traded options may have wide bid-ask spreads, making it expensive to enter or exit a position. Illiquid markets increase slippage risk and decrease pricing efficiency.

Exercise and Assignment Risk

Sellers of options, particularly those writing naked calls or puts, face the risk of being assigned shares at unfavourable prices. For example, a naked call writer may be forced to provide stock at a price far lower than its market value, resulting in substantial losses.

Complexity of Strategies

Multi-leg strategies, such as iron condors, butterflies, or calendar spreads, require extensive knowledge and ongoing monitoring. Errors in execution or misunderstanding the payoff profiles can result in unexpected results or significant losses.

Emotional and Cognitive Bias Risks

Options trading requires discipline and objective decision-making. Emotional reactions to market moves can lead to hasty decisions, such as prematurely closing viable positions or doubling down on losing trades.

Regulatory and Taxation Risks

Options regulations can change based on market dynamics and political developments. Additionally, options can involve complex tax treatment, making accounting and compliance more challenging for active option traders.

Education and Strategy Are Essential

To mitigate these risks, investors should:

• Engage in thorough education before trading options.
• Start with basic strategies like covered calls or protective puts.
• Use risk management techniques such as stop-loss orders or position sizing.
• Only invest capital they can afford to lose.
• Consult professional financial or tax advisers if unsure.

While options can enhance a portfolio’s flexibility and performance, they are inherently risky tools. Sound understanding and prudent strategy are the best defences against the possible downsides of options trading.