For any profession, once you have done it for a while, some concepts become second nature to the point that you forget that not everyone (or very few) understands them at even a basic level.  I find that options are the concept that confuses people the most and one that is perhaps most valuable to understand.  The futures industry uses these instruments in a variety of ways that you can apply to your own portfolio as well.

At their most basic level options convey the right to buy or sell or a specific price.  If you purchase a call, you are betting that the market will go up past the level of the call strike price.  You keep the difference between how much you paid for the call (the premium) and how high above the strike price it expires.  Conversely, if you purchase a put you gain when the market drops below the level of that strike.  These roles are reversed if you sell the call and the put.  See chart below.

Market RisesMarket Drops
Owner of callGainsLoses
Owner of putLosesGains
Seller of callLosesGains
Seller of putGainsLoses

The beauty of options is that they provide flexibility.  Suppose you believe that you are in a potentially overvalued stock position but do not want to sell and lose potential gains.  A covered call is sold to sit above an existing position that you own.  You get paid a premium for the sale and if the stock rallies you have to sell at the strike price that the option was sold at.  If the stock drops or does not rise past the level of the strike, you keep the premium and can sell a new option.

Example: Stock purchased and rises to $100.  You sell a call at $110 for $3.  At expiration, the price is at $109.  You keep the $3 premium and the stock gain of $9.  Alternatively, the stock is at $115 at expiration.  You make $13 ($10 gain to $110 plus the $3 premium) and the buyer of the option makes $2 ($5 gain less the $3 premium).

Positions can also be uncovered, or in option terms “naked”, which means you are only limited in losses to the range of the stock.  Last year we saw a number of funds get hit very hard with naked options on AMC or unhedged positions in the same.  In the chart below, a seller of a naked put at $80 could lose the full amount down to $0 assuming a stock becomes worthless.  The seller of a call has no upper limit on losses as stocks could go up to any level technically.

Stock to 110 at expirationStock to 70 at expiration
Owner of 100 callGains 10 less premiumLoses premium
Owner of 80 putLoses premiumGains 10 less premium
Seller of 100 callLoses 10 but makes premiumGains premium
Seller of 80 putGains premiumLoses 10 but makes premium

A final option for both buyers and sellers who want to make a prediction but limit their risk can enter a spread trade.  These can get very complicated but the simplest version would involve buying and selling separate calls or puts at different strike prices.  One “leg” of the trade would cost money and the other would receive premium.

Example: ABC is awaiting approval of a new product.  If it is approved you believe it could go up significantly but you weigh the odds at 50/50 so you want to limit risk.  Currently it is priced at $100.  You purchase a call at $110 for $5 and sell a call at $120 for $2.  You have risked $3 ($5-$2) for a potential gain of $7 ($10 on the option less the $3 premium).  If ABC drops you will lose $3.

We have seen an explosion of option activity as the users of Robinhood (HOOD) and other online applications utilize these instruments to participate in shares they otherwise could not afford.  Each equity option controls 100 shares so if Peloton (PTON) is at $100 per share it would take $10,000 to purchase.  Alternatively, one could pay $400 for the $110 call and limit their risk and upfront cash outlay.  This new dynamic will create opportunities across all markets.  Just a little bit of option knowledge might help you take advantage.

While we specialize in evaluating futures programs here at IASG, we see a LOT of trading and spend much of our time educating.  Please reach out if you have questions.  We will be happy to answer them as best we can.

Image by Elchinator from Pixabay