INVESTMENT STRATEGIES

WHAT ARE OPTIONS AND HOW DO THEY WORK?

Robert Hum, CAIA Sep 03, 2024 Equity

Learn about options and how they can be incorporated into an investment portfolio.

SO, WHAT ARE OPTIONS?

Options are contracts between two people (or companies or traders) who are willing to buy or sell an investment at a specific price in the future. By fixing the price of the investment, options can provide the buyer of the option protection from a decline in price combined with the flexibility to wait and see how the price of the investment changes before purchasing. Below we outline the basics to help you understand how options and option ETFs can be used in an investment portfolio.

There are two kinds of option contracts: Puts & Calls.

 

Both allow the buyer of the contract to guarantee a specific price for a stock or ETF for a specific amount of time. Puts allow an investor to guarantee the price at which the stock or ETF can be sold while calls guarantee the price at which it can be bought.

 

In both cases, the purchaser of an option always has the right to decide if the option will be used, otherwise known as exercising the option, or do nothing and let it eventually expire.

 

In exchange for this flexibility, the buyer of an option pays the seller, which referred to as an option premium.
Video 00:57

HOW DO OPTIONS WORK?

When it comes to options, it can be easy to get overwhelmed by the jargon. Watch this video to understand the basics without a whole new vocabulary.

There are two kinds of option contracts: Puts & Calls.

 

Both allow the buyer of the contract to guarantee a specific price for a stock or ETF for a specific amount of time. Puts allow an investor to guarantee the price at which the stock or ETF can be sold while calls guarantee the price at which it can be bought.

 

In both cases, the purchaser of an option always has the right to decide if the option will be used, otherwise known as exercising the option, or do nothing and let it eventually expire.

 

In exchange for this flexibility, the buyer of an option pays the seller, which referred to as an option premium.

THE BASICS

Options come with a lot of jargon, which can be intimidating, so here is a breakdown of the most important terms:

  • Puts vs. Calls
    • Call: A call option provides the purchaser the ability to buy a stock or ETF at a predetermined price.
    • Put: A put option provides the purchaser the ability to sell a stock or ETF at a predetermined price.
  • Underlying security: The underlying security is the stock, ETF or other security the option contract is for.
  • Strike: The strike is the pre-determined price at which the security is to be bought or sold.
  • Premium: The cost of an option contract, paid by the purchaser in exchange for the flexibility to buy or sell a stock or ETF at a predetermined price.
  • Exercise: When the buyer of a call (put) option elects to buy (or sell) the stock or ETF at the predetermined price (strike).
  • In the money option: When a call (put) option strike price is below (above) the current price and exercising the option would result in a gain.
  • Out of the money: When a call (put) option strike price is above (below) the current price and exercising the option would result in a loss.
  • Breakeven: When the difference between the strike price and market price is large enough to offset the cost of the option premium. For a call option, the strike price would need to be below the current market price and for a put option, the strike price would need to be above the current market price.
  • Expiration: The expiration is the last day the contract can be exercised, or used to exchange the security at the strike price.

WHY INVEST IN OPTIONS?

Express a view:

For a fee (the option premium), an investor can express a view on if a stock’s price will rise or fall. For example, if an investor believes the stock price will rise in the future, they can purchase a call option and wait for the stock to rise before exercising the option to purchase at the lower price (or simply sell the option contract at the new, higher value). If the stock price falls, the option holder has the freedom to just walk away without any additional obligation other than the cost of the premium.

Generate income:

Investors can target income by selling options in order to capture the option premium. A covered call generates income by selling a call option, otherwise known as writing a call, on a stock or ETF held in the same portfolio of investments. This strategy sacrifices potential growth from the underlying security in exchange for income. The strike price of the call option is a major factor in determining the option premium. All else equal, a higher strike price will result in a lower premium while providing some potential for growth and vice versa for a lower strike price. When implementing a covered call strategy, the key is to strike the right balance between growth and income.

Writing options requires special permission on an investment account, as well as, ongoing maintenance for certain strategies in terms of monitoring strike prices and selling new options as the current ones expire. Today, investors can access covered call strategies via certain ETFs, allowing income-oriented investors to potentially benefit from these sophisticated strategies with the ease of purchasing a stock.

Investors can generate income by selling call options. Here’s how it works.

 

By selling a call option on a stock they already own, the seller receives the option premium. By selling a new option each time existing one expires, the investor can secure periodic income through the option premiums.

 

This is a great way to diversify income sources, however, as always with options, there is a trade-off. For covered calls, the tradeoff for receiving the premium is the possibility that the stock price will rise above the strike, the call option will be exercised, and the stock will have to be sold at the lower pre-agreed price, effectively capping the potential for growth.

 

A lower strike results in a higher premium and vice versa. The trick is finding the right balance.
Video 01:02

ACCESSING INCOME WITH COVERED CALLS

Investors searching for income maybe interested in a covered call strategy. Watch this vides to see how it works.

Investors can generate income by selling call options. Here’s how it works.

 

By selling a call option on a stock they already own, the seller receives the option premium. By selling a new option each time existing one expires, the investor can secure periodic income through the option premiums.

 

This is a great way to diversify income sources, however, as always with options, there is a trade-off. For covered calls, the tradeoff for receiving the premium is the possibility that the stock price will rise above the strike, the call option will be exercised, and the stock will have to be sold at the lower pre-agreed price, effectively capping the potential for growth.

 

A lower strike results in a higher premium and vice versa. The trick is finding the right balance.

Target Protection:

A protective put uses a put option to help mitigate losses due to potential drops in price for a stock owned by the investor. The put’s strike price sets a floor at which the stock can be sold.

Options can also be combined to create a range of strategies for a variety of potential outcomes. For example, if an investor wants to protect an investment from a 10% decline in price, but is not concerned with a larger decline, then the investor can use a series of puts to create buffer with that specific range. In this case, the investor can purchase a put with a strike equal to the current market price and sell a second put at strike price 10% lower than the current market price. The option premium received from the second put can help offset the cost of the strategy. The total cost can be further reduced, or completely neutralized, by selling a call option in addition to the put spread. Just remember, by selling a call option, the strategy will now have a limit on potential growth.

iShares Buffered Equity ETFs can help investors access strategies that offer a range of downside protection in exchange for a cap on the potential gains.

Put options can be used to help protect investments from losses.

 

The more a stock’s price rises, the greater the profit. Of course, the opposite is also true and as a stock’s price falls, the investment can result in a loss.

 

Purchasing a put results in a minimum price at which the investment can be sold for a set period of time. This minimum is determined by the strike price and is often referred to as a floor. This is referred to a protective put.

 

Moderate drops in price, maybe falling 5 or 10% are far more common than a stock’s price dropping all the way to zero. Investors seeking to protect against these moderate drops in price can help lower the cost of the protective put by selling an additional put at a lower strike. This range of protection can be adjusted to meet any investor’s need.
Video 00:59

MANAGING RISK WITH PROTECTIVE PUTS

Put options can help investors set a minimum price a stock can be sold for or create a range of downside buffer. Watch this video to learn more about protective puts and put spreads.

Put options can be used to help protect investments from losses.

 

The more a stock’s price rises, the greater the profit. Of course, the opposite is also true and as a stock’s price falls, the investment can result in a loss.

 

Purchasing a put results in a minimum price at which the investment can be sold for a set period of time. This minimum is determined by the strike price and is often referred to as a floor. This is referred to a protective put.

 

Moderate drops in price, maybe falling 5 or 10% are far more common than a stock’s price dropping all the way to zero. Investors seeking to protect against these moderate drops in price can help lower the cost of the protective put by selling an additional put at a lower strike. This range of protection can be adjusted to meet any investor’s need.

FREQUENTLY ASKED QUESTIONS

An option is a contract between two people who are willing to buy or sell an investment, often a stock or ETF, at a specific price in the future. In this contract, the buyer of the option chooses if the investment will be exchanged at the predetermined price and in exchange for this flexibility the option buyer pays the seller a fee otherwise known as the premium. Options are often viewed as a type of insurance, by giving the participant tools to help navigate changes in price.

An option on a stock is a contract that allows the purchaser to buy (call) or sell (put) a stock at a predetermined price for a set amount of time. In exchange for having this option, the buyer of the option pays the seller a fee (premium). In short, options are give the purchaser a tool to help navigate changes in price.

No, a call option allows the owner to purchase the stock at a pre-agreed price for a predetermined amount of time. If the stock price rises above the strike price, the owner of the option benefits because they can exercise the option and purchase the stock at the lower price. If the stock price falls, the owner of the option can choose to do nothing and is not impacted by the drop in price. As a result, a call option enables the owner to benefit from increasing stock prices but does not subject them to the principal risk of a price decline.

An option is a contract between two people who are willing to buy or sell an investment, often a stock or ETF, at a specific price in the future. In this contract, the buyer of the option chooses if the investment will be exchanged and in exchange for this flexibility, the buyer pays the seller a fee. This fee is known as premium. Option contracts are only valid for a set period of time and at the end of the contract is known as the expiration date. If the buyer exercises the option, they are choosing to exchange the investment at the predetermined price. An American option allows this trade to occur at any time before expiration and a European option only allows for a trade at expiration. Options can be for the purchase of an investment (call option) or the sale of an investment (put option).

Options may be utilized for a variety of reasons including, taking a view on the future price of a security, mitigating losses due to a price decline in a stock or ETF holding, or securing income by selling options in exchange for a premium. By combining a series of options, investors can create specific outcomes, like specific levels of protection or enhanced income. iShares offers convenient access to these strategies in the form of an ETF. Learn more about how to target downside protection with iShares Buffer ETFs or seek to enhanced income with iShares BuyWrite ETFs.

Options trading is buying and selling options. While investors often use options for a specific purpose (expressing a view on a stock or ETF, targeting income, or protection), option traders are focused on determining the probability of a stock or ETF exceeding the strike price in order to assign a value to the option. Option prices are based on complex mathematical models which factor in the current stock price, option strike price, volatility of the stock or ETF and length of time before expiration.

The two types of options are puts and calls. A call option allows the owner of the option to buy a stock or ETF at a pre-specified price while a put option allows the owner to sell a stock or ETF at a predetermined price. Both put and call options are only usable for a pre-determined number of stocks or ETFs and for a certain amount of time, after which the option expires.

People often buy a put option for protection from a drop in the price of a stock or ETF.

Three major risks associated with options:

  1. Market risk: Market risk is the risk of a change in stock or ETF price due to a change in the overall market. Buyers of option contracts decide if the stock or ETF will be traded at the predetermined (strike) price. As a result the buyer of the option is protected from market risk associated with a change in price for the underlying stock or ETF. The seller of the option does not have this luxury. If the underlying stock or ETF exceeds the strike price, the seller will likely be forced to sell at a lower price than the current market price or purchase at a higher price than the current market. In order to protect against this scenario, the option seller charges the buyer a premium.
  2. Credit risk: Credit risk is the risk that one of the two parties (option buyer or seller) does not fulfill their end of the contract. Today, many options are traded on an exchange, limiting credit risk.
  3. Operational risk: Operational risks are related to the human element in implementing and settling the option strategy, including selecting the right terms for the option, ensuring it is exercised if needed and settling the trade. iShares ETFs provide access to option strategies with the ease, simplicity of an ETF. Learn more about how to target protection with iShares Buffer ETFs or enhanced income with iShares BuyWrite ETFs.

For options traded on an exchange, when an option buyer chooses to exercise the option it is assigned to an option seller to fulfill the terms of the contract. This process is referred to as assignment. In the case of a call option, the option seller will have to sell the underlying security at the strike price (physical settlement) or provide a payment for the difference between the current and strike price multiplied by the number of shares (cash settlement).
Photo: Robert Hum, CAIA

Robert Hum, CAIA

US Head of Factor and Co-Head of Outcome ETFs

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