We often get questions about options (although we do not incorporate them into our clients’ wealth management plans). These questions range from curiosity about the impact of trading options on the overall market to pointed ones about buying call options on a particular index or individual stock.
The focus on options trading was magnified in late 2020 and early 2021. According to the Options Clearing Corp, options trading hit a record in 2020, with some 7.47 billion contracts traded. This was 45 percent higher than the previous record from 2018. (*NY Times article 1/25/2021). These headlines coincided with some very outsized moves in stocks like GME, AMC, etc.
Having worked on a hedge fund trading desk for more than 15 years, I wanted to use this blog to share the mechanics of options. Let’s start with some basics:
A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, standardized contracts known as listed options trade on exchanges. Option contracts give the owner rights and the seller obligations. Here are the key definitions and details:
Call option: A call option gives the option owner the right to buy a specific number of shares of the underlying security at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock.
Put option: Put options give the option owner the right to sell a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking.**
Other basics about options include 1 contract usually equals 100 shares of the underlying stock. Options always have an expiration date, and there are multiple things that make up the price of an option, including volatility, days from expiration, stock price, etc.
For this blog post, let’s stick with two basic option trades, buying a call and buying a put. Buying a call means you are bullish on the price of a stock, ETF, or index. In more complicated strategies long calls can be used to hedge upside in a short position, but for this example we are sticking with the basics.
If you have $5,000 to spend on an investment in XYZ, which is currently trading at $100, you can buy 50 shares. During the next month XYZ rises to $115, your investment will rise to $5750, or 15% paper profit.
The other option would be to look at a call option with a strike price of $100 that expires one month from now costs $5.50 per share or $550 per contract. Based on the $5k budget, you can buy nine option contracts, or the equivalent of 900 shares of the stock. If the stock rises over the next month 15% to $115 at expiration, the option will be in the money worth $15 per share, or $13,500. The net dollar return is $8500. This is much higher than just buying the stock outright.
The downside of buying calls is limited to the price you paid for the options. For this example (see image - Buying Calls), the loss potential would be $5000, same as with the stock purchase.
The next example (Buying Puts) involves buying a put option, which usually means you are bearish on a particular stock, ETF, or Index. Put options gain in value as the stock price decreases, but like a long call option, your downside is limited to what you pay for the option contract. This strategy is much less risky than short selling stock, which has unlimited downside as the stock price has no limit on the upside.
These examples are very basic, and most option trading is much more complicated, which is why we recommend options trading be left to the professionals. The rise in option trading in 2020 was magnified by flocks of small new investors many of whom were working/schooling virtually, flush with stimulus checks and full of time. Earlier this year, the skew, which shows how many contracts are betting on gains compared with those betting on losses (i.e., put options), was tilted bullish to levels not seen since 2000.
The conclusion isn’t to say the above-mentioned option traders were wrong. Clearly the market has continued higher over the course of the 2021. The bigger picture is to emphasize that option trading is complicated, and if an investor decides to go down that route, they must be aware of the risks involved.
Please note: This is an educational piece only. We do not currently trade options in our clients’ portfolios or as part of their overall wealth management plans.
Carrie King is the Director of Trading and the Chief Compliance Officer at Ullmann Wealth Partners. Prior to joining the firm, Carrie worked as a trader, responsible for trading options as well as other securities.