Options: Double The Return with Quadruple the Risk

In the last 30 days you’ve probably overheard someone (particularly one of your less investment-savvy friends) talk about buying options. Have you ever wondered what the pundits mean when they talk about “The Powell Put?” Whether it’s your co-worker, nephew, or college buddy, millions of Americans are starting to flood into the options market to catch huge returns in a short period of time. Options are emerging as the next trading conduit for millennials to see “risk-free” returns incredibly quick.

Thanks to free option trading services, individuals have begun trying their hand at options trading for the first time. (For more details on the Robinhood traders- see Tyler’s article here). Below is a graph showing the immense growth seen this year in single stock option volume.

In addition to these random amateurs bloating about options, there are innumerable tweets from professional investors/traders describing their interactions with amateur American investors over the internet.

If you’re new to the world of equity options contracts, I’m going to do my best to synthesize the basics of a trillion dollar industry into one single blog post; bear with me if these thoughts seem all over the place!

How do Options Work?

With all the new buzz about options, you might ask yourself: how well do you know options? 

Now, this answer has many levels to it; everyone has their own strategies with options and different methodologies for managing their portfolios. There are countless types of trades you can make, dates of options you can trade, and underlying stocks to trade. I’ll do my best to keep it simple and highlight the basics.

The purpose of this article is to highlight the risks you face when investing in options before you go blowing up an account!

What Are They?

According to Investopedia, options are financial instruments that are derivatives based on the value of underlying securities.

We will put it into layman’s terms. An option is a contract that gives you the right to buy (or sell) 100 shares of an equity at a predetermined date at a predetermined price. See below:

In this example I picked Tesla, everyone’s favorite. I’ll walk you from the basic options chain all the way down to a specific contract! 

Call Options

Today, Tesla closed at $419.62. Since you’re a big fan of the Model 3 and expect revenue growth to skyrocket with European/Asian sales, you project Tesla to move to $500.00 by year end. Additionally, you’ve seen your favorite twitter critique project a price target of $480.00 through Q3.
Therefore, you think that the price of 1 share of Tesla will be $490.00 by December first. Instead of forking over $41,962 (100*419.62), you decide to buy 1 call option at $490.00 in December for $5,905.

Again, paying $5,905 for this contract gives you the right to buy 100 shares of Tesla on December 18th for $490.00.

So, think about the economics this way: 

If Tesla is trading for $600, you’ll have the right to buy 100 shares at $490 ($490*100=49,000) and sell the 100 shares for $600 ($600*100=$60,000).

You’ll make $5,095 ($60,000-$49,000-$5,905=$5,095)

Therefore, you put up $5905 to make $5,095; nearly 100% return!

If you would’ve decided to purchase $100 shares, you would’ve had to spend $42,000 to get $18,000

$42,000 ($419.62*100)

-$60,000 ($600*100) 

$18,000

This is only a 42% return! So economically speaking, the options seem like a great option right? Why would anyone buy stocks again when they can get a massive return in a shorter period of time?

WAIT, there’s one risk that we haven’t even discussed. Since the options are CONTRACTS, they will have no value if they are not in-the-money at the time of expiration…

In-The-Money: an option has value in a strike price that is favorable in comparison to the prevailing market price of the underlying asset

Therefore, if Tesla is trading at $420.00 at the time of expiration, the options contract is worthless!

If you would’ve chosen to just buy 100 shares of Tesla for $419.62, your investment would actually be up $380 ($420-$419.62 *100). 

For our readers that are more visual learners than readers, I recommend a few of the following links to get options down:

More details on Options Trading
Another great video on Options trading

Put Options

In our last example of Tesla, we projected the stock to be at $490 on December 18th. What if we were big Tesla Bears and thought the stock would be at $392 on December 18th? Lucky for you there’s a long side and a short side (Call options and Put options)!

Put options give investors the ability to make a bearish trade on a stock without shorting it. If Tesla closed at $340 on December 18th, you’d earn $4,800 (($392-$340*100) minus the price of the contract.

Pretty simple, right?

Does the concept of “The Powell Put” make sense now? 

Similar to “The Greenspan Put,” “The Powell Put” is a contractual obligation giving its holder the right to sell an asset at a particular price to a counterparty. The put option can be exercised if asset prices decline below the put price, protecting the holder from further losses.

Options: Next Steps and the Road Ahead

Now, I’ve only scratched the surface on the basics of a call contract and a put contract. There is a spectrum of strategies that investors use to make plays on stocks. Some folks prefer to sell (short) contracts, pair calls with puts, and so on.

I encourage you, as a FourEyesFinance reader to dig a lot deeper into options, trading psychology, and how others are utilizing these powerful contracts to drive large returns in their portfolio. 

I warn you again though, options are much riskier than owning underlying stocks but offer the potential for greater return in a much shorter period of time.

Trade well!

You Might Also Like

You Cannot Stop Cryptocurrency

Cryptocurrency in the past few months has been exploding. While many are excited about the astronomical gains, its led to many skeptics questioning the entire crypto space. They are partially correct, however the entire cryptocurrency space should not be discounted, and in fact there should be more buy-in once this bull run has finally simmered down.

Read More »

Leave a Comment

Your email address will not be published. Required fields are marked *

Never Miss a Perspective.

Subscribe now to our newsletter to stay informed.

As a thank you, Tyler will give you his custom investment tracker, free!