Make 2016 a Year of Smart Investing with Equity Options

01/21/2016 7:00 am EST

Focus: OPTIONS

Joe Burgoyne

Director, The Options Industry Council

ADVERTORIAL—Joe Burgoyne of The Options Industry Council (OIC) thinks it’s time for investors to stop being afraid every time the market moves (or doesn’t). Instead, by taking advantage of these basic principles of options, investors can construct options strategies to realize many different outcomes in up, down, and sideways markets.

It’s often said there are primarily two emotions in investing, fear and greed. Considering the recent volatility in the markets, it’s no wonder investors have felt a lot of the former. Looking ahead, it’s time to stop being afraid every time the market moves (or doesn’t) and start embracing those opportunities through smart investing with equity options.

Options are financial instruments that offer opportunities and can be used in many different ways in investment portfolios. Depending on the desired outcome, investors can utilize options to generate income, hedge a concentrated stock position, initiate a directional play, reduce risk, or for leverage. Any of these outcomes are possible with a little understanding of how options work.

An option gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before its expiration date. Conversely, the seller of an option takes on the obligation to sell or buy that asset at the specified price should it be exercised on or before its expiration. In equities, one standard options contract represents rights to 100 shares of the underlying stock or ETF.

There are two types of options: a call, which gives the holder the right to buy the underlying security and a put, which gives its holder the right to sell the underlying security. Whether buying or selling, every option has six specified elements. These are position size, underlying, expiration, strike price, option type, and option premium. This typically is expressed as “Long 1 XYZ January 80 call at $3.00.”

Looking closer at the above example, we see the investor has bought one call option, paying a premium of $3.00 per share ($300 total transaction value) for the right to buy stock XYZ for $80 a share any time on or before January expiration (third Friday of the month).

At any point in its life, an option is in one of three states:

  1. Out-of-the-money, at-the-money, or in-the-money. Looking at our example above, the option would be out-of-the-money anytime the underlying XYZ is trading for less than $80;
  2. At-the-money if it was trading at $80;
  3. In-the-money anytime XYZ was listed for more than $80. If it were trading at $85, we could exercise our in-the-money option to buy 100 shares for our strike price of $80, netting a $2 profit per share after accounting for the $3 premium we paid.

Using these basic principles, investors can construct options strategies to realize many different outcomes in up, down, and sideways markets (many of which we will be investigating further in this column in the coming months). In the meantime, more free options education is available online through OCC’s Options Industry Council (OIC). The OIC is the leading provider of online educational content in the equity options industry.

DISCLAIMER: OPTIONS INVOLVE RISK AND ARE NOT SUITABLE FOR ALL INVESTORS. INDIVIDUALS SHOULD NOT ENTER INTO OPTIONS TRANSACTIONS UNTIL THEY HAVE READ AND UNDERSTOOD THE RISK DISCLOSURE DOCUMENT CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS AVAILABLE BY VISITING WWW.OPTIONSEDUCATION.ORG.

ANY STRATEGIES DISCUSSED, INCLUDING EXAMPLES USING ACTUAL SECURITIES AND PRICE DATA, ARE STRICTLY FOR ILLUSTRATIVE AND EDUCATIONAL PURPOSES ONLY AND ARE NOT TO BE CONSTRUED AS AN ENDORSEMENT, RECOMMENDATION OR SOLICITATION TO BUY OR SELL SECURITIES. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. COPYRIGHT © 2016 THE OPTIONS INDUSTRY COUNCIL. ALL RIGHTS RESERVED.

Joe Burgoyne, Director, The Options Industry Council (OIC)

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