What are Options?

Hello Everyone,

Today I would like to talk to you about options. Options are a financial instrument that are very misunderstood. This is understandable because they are very complicated and work very differently than other financial instruments. That being said, options are my new favorite way to invest and I believe are the future of investing as the technology gets better and costs to trade come down.

Options are derivative securities meaning that the price of an option is derived from the price of an underlying asset. For today's purposes we will talk about options on SPY which is the exchange traded fund (ETF) indexed to the S&P 500.

By definition an option gives you the right to buy or sell an asset at a specific price in the future. There are two types of options- puts and calls. A call option would be bought if you believe that the underlying assets will increase in value. Here's an example...

Today SPY is at 140.93. I believe that the S&P 500 is going to rise. Therefore I am gong to buy a call option on SPY with a strike of 141. Say that one week from now SPY rises to 145. I can choose to exercise the option and buy the SPY at a price of 141 and immediately sell it in the market at 145, resulting in a profit of $4 per share.

Another characteristic of options is leverage. One call option represents 100 shares of the underlying assets. Therefore in this example you have made $400 on one call option! However you did have to pay for that call. What you paid to buy the call is called premium. Today it would cost about $100 in premium to buy a one week call option at 141. Therefore you would have netted about $300, or a 300% return. Where as if you had purchased 100 SPY shares at 141 and sold at 145 you would have had to invest $14,100 instead of $100! That is the power of leverage. When you buy an option the most you can lose is the premium you paid for the option. In this example $100.

The same concept is true for a put option, only when you buy a put option you are betting that the market will go down. Using a similar example as above, today the SPY is at 140.93. You buy a put option at 141. In one week SPY drops to 137. You now have the right to borrow 100 SPY shares at 137 and sell them at 141, making $4 per share. Don't forget that you had to pay for that put option. Today it would have cost you $120 to buy the put. So, you made $400 you paid $120 and you netted $280. The most you could have lost in this trade is the $120 you paid in premium to buy the put option.

I am going to leave you to ponder the concept of buying options. I will explain selling options soon. Then we can move on to more complicated option trades such as spreads, butterflies and iron condors.

As always, I welcome all questions!

Cheers,

Breana