The market is a crazy and dangerous place. As a result, stock prices can swing wildly one way or the other, and retail investors like you and me can feel like we're along for the ride and that big money traders control our financial destiny.
But there are tools available for minimizing some of the risk in our portfolios. Stock options can play an important role in buying and selling stocks. You don't have to be a professional options trader. Just know a few of the basic rules of the game to make it work for you.
Knowing the basics
There are two kinds of basic options investors can use: calls and puts. Calls give the owner the option to buy a stock at a set price on a set date. Puts give the owner the option to sell at a set price on a set date. They also represent a "bet" on what direction the stock is headed. A call owner wants the stock to go up, and vice versa.
|
Option Type |
Buyer |
Seller |
|---|---|---|
| Calls | Long stock | Short stock |
| Puts | Short stock | Long stock |
So let's take a look at LED light maker Cree (Nasdaq: CREE). If I think the recent drubbing the company took is a little overdone and I want to be long the stock, I have three choices:
- I could buy shares, earning profits if shares go up but losing money if they go down.
- I could buy a call option, paying a fixed amount upfront to give me the right to buy shares later at a given price. That way, I can only lose what I paid for the option, but I still have unlimited upside.
- I could sell a put option, committing myself to pay a fixed price for shares even if the stock falls below that value. In the meantime, I'd pocket the money I received when I sold the option.
The price of put and call options depends on the price of the underlying stock as well as two other important factors.
Putting time on your side
Part of the value of an option comes from how long you have until the option expires. In general, the longer an option has until expiration, the more valuable it is.
If you want to make a bet that biotechnology firm Dendreon (Nasdaq: DNDN) is going up after big name investors Ken Griffin, Stephen Cohen, George Soros, and David Shaw took large positions in the company, you may want to buy calls. Conversely, if you're sitting on big gains after ATP Oil & Gas' (Nasdaq: ATPG) long run higher following the reopening of the Gulf to drilling and want to lock in some profit, writing calls can earn you a quick option premium payment. The length of the option you chose affects the price you either pay or receive for the option as you can see below.
|
Company |
Option Strike Price |
April Call Price |
May Call Price |
|---|---|---|---|
| Dendreon | $38 | 1.27 | 2.61 |
| ATP Oil & Gas | $18 | 0.43 | 1.24 |
Source: Yahoo! Finance.
As you can see above, the May options for these companies are more expensive than the same April option. This is simply because the May option has more time left on it and more time for the option price to decay.
Don't be afraid of volatility
Volatility is another main component in pricing an option and can be a great tool for those of us who invest in volatile markets. Two sectors I follow closely -- solar and gaming -- are extremely volatile, and options can come in very handy.
How do you spot a volatile stock? Just check out a stock's beta to get a good idea. Two stocks with a similar stock price but vastly different betas will have great differences in option prices. For example, according to Yahoo! Finance, Las Vegas Sands (NYSE: LVS) has a beta of 4.07, while a similarly priced stock, Disney (NYSE: DIS), has a beta of 1.19. The vast difference in option prices shows how this affects option values.
|
Company |
Recent Stock Price |
Option Strike Price |
May Call Price |
May Put Price |
|---|---|---|---|---|
| Las Vegas Sands | 44.70 | $45 | 2.80 | 3.05 |
| Disney | 42.55 | $43 | 1.20 | 1.52 |
Volatility can come from a lot of places, but in the case of Las Vegas Sands, it comes from a highly leveraged business -- and the risk a casino operator takes as a result. Disney, on the other hand, owns a much more steady business with theme parks, movies, and television networks. As a result, Disney's options don't cost as much as options on Las Vegas Sands. It doesn't make one or the other a better investment -- it just affects the price of their options.
Those are some of the basics of how time and volatility work for option prices. Stay tuned tomorrow as I continue my look at options with a strategy that lets you buy stocks at a discount or sell them at a premium.
