Sunday, April 10, 2011

The Unintelligent Investor's Definition of the Week: Option


Definition from Oxford Dictionary:
Noun, a right to buy or sell a particular thing at a specified price within a set time.

Definition from The Free Dictionary:
The exclusive right, usually obtained for a few, to buy or sell something within a specified time at a set price.
(Business/ Commerce) an exclusive opportunity, usually for a limited period, to buy something at a future date
(Economics, Accounting & Finance/ Stock Exchange) Commerce the right to buy (call option) or sell (put option) a fixed quantitiy of a commodity, security, foreign exchange, etc., at a fixed price at a specified date in the future.

Confused yet? Lol lets hope I don’t make it worst.

Explanation by the Unintelligent Investor:

First of all, an option is a derivative, which means its value is derived from an underlying asset, e.g. stock, commodities, real estate, etc.

Let’s try and understand buying options first because I think once we understand that, selling options are pretty straight forward. Note that I’ll be focusing on shares as the underlying asset.

Basically, there are two types of options that you can buy. Call options and put options.
If you buy a call option, you buy the RIGHT but not the OBLIGATION to buy an asset at a fixed price on a fixed date.
If you buy a put option, you buy the RIGHT but not the OBLIGATION to sell an asset at a fixed price on a fixed date.
The money that you pay up front to buy the option is called a premium
That fixed price is called the strike
And finally the fixed date is called the expiry date.

If I have confused you further, I’m very sorry but I hope this example will help you understand.

Everybody loves sales, so I’ll use that as an example,

Say one day you walk into a store that was having a massive sale. You find this shirt that you really like and decide that you might want to buy it but then, you are not too sure. What if you find another shirt that you like more in another store. You only have enough money to buy 1 shirt so now you have a dilemma, should you buy this shirt? Or should you go look around another store and risk the chance of not being able to buy this shirt because sales end today so the price of that shirt will shoot back up to its original price.

The shirt is worth 100 dollars, and it was discounted to 30 dollars. So you walk up to the store owner, who let’s just say happen to be the Unintelligent Investor and he tells you, why not you pay 3 dollars now and I’ll put it on hold for you until the end of the day. If you decide to buy it at the end of the day, just pay the 30 dollars and it is yours, if you decide not to, you’ll only lose the 3 dollars that you paid for me to put it on hold.

Bingo, you’ve just bought a call option from the store owner (who is selling the call option)

So in this case, the shirt is the asset.
30 dollars is the strike price (at the money, because the strike price is similar to the underlying price)
3 dollars is the premium
And end of the day is the expiry date.

Now let’s substitute that shirt for shares.

Look at the chart below, once again taken from bull charts (which is the software that I use, unfortunately I’m not getting any sponsorship at all from them lol)

You can see that the price at its high was almost 32 dollars and all of a sudden it drops all the way down to 12 dollars and now it looks like it might be going up again. However because the financial crisis had just started, you have no idea what is going to happen to the banking industry. You want to have shares in ANZ but you don’t want to lose all your capital.

So you can buy a call option. So if you buy a call option with a strike price of 17 dollars with an expiry date of 6 months, you buy the right to buy ANZ at 17 dollars even if the price goes up.

Say in 6 months, the price goes up to 25 dollars, that is when you exercise your right to buy ANZ at 17 dollars (from the call option seller) and then you can sell it back to the market for 25 dollars and make a healthy profit.

On the other hand, if the price drops to 5 dollars, you will not exercise your right to buy the shares because that will mean that you have to pay 17 dollars per share for something that is only worth 5 dollars. In that case you only lose the premium that you’ve already paid (to the call option seller)

So effectively, you are limiting your losses for potentially infinite return. If I have to draw a graph it will look like this.

This is a pay-off diagram and it is drawn for almost every option strategy.
As you can see, you had capped your losses and potentially can make an infinite gain

Pay off diagram for buying a call option

Compare that to the pay-off diagram for buying the shares itself
Pay off diagram for buying shares

As you can see, you still have the potential to make an infinite return but you also stand to lose all the capital you put in.

I hope this post has been helpful for you guys, I tried my best to explain buying call options and hope I did not confuse the heck out of everybody because they are highly complex derivatives. I’ll talk about buying put options in next week’s Unintelligent Investor’s Definition of the Week and hopefully the post won’t be as long.
There are a lot more to options than what I’ve typed in this post. Like I’ve mentioned they are highly complex derivatives.

I guess the main purpose of this post is to explain what options or buying call options are about so that when we read about it or hear about it, we know what they are talking about. By no means am encouraging you to speculate in options. Speculating options takes a lot of time, skill and experience and it carries a huge amount of risk because of the leverage involved.

Thanks for reading this incredibly long post, I really hope I’ve been helpful, please comment or send me an email to let me know if I explained it well enough or if it was just crap, I would love to read your feedback. Do click on the little icon on the right side of the screen to like the page on facebook or follow me on twitter! Thank you once again.

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