What are options
Options can open up new possibilities for your clients’ portfolios. They allow investors to act on specific expectations about how a stock might move and when those changes could happen. This is instead of sticking to the usual approach of buying or selling stock.
In this article, Wealth Professional Canada will highlight what options are, how they work, and more!
Options are contracts that give the holder the right, but not the obligation, to buy or sell a specific stock at a set price by a certain date. This right can be bought and sold in the market, and most options are traded on exchanges rather than directly between investors. That means that your clients can also sell their options before they expire, not just exercise them.
Each options contract usually covers 100 shares of the underlying stock. The price that your clients see quoted for an option is per share, so the total cost is that price multiplied by 100. For example, if an option has a quoted price of $5, it will cost $500 per contract.
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Like other types of derivatives, options can be used for purposes such as hedging risk or speculating price movements.
Options profit calculator
How does options trading work?
When your clients buy an option, they are not buying the stock itself. Instead, they are buying the right to buy or sell the stock at a specific price on or before the expiration date. This is called the strike price.
Types of options
There are two main types of options that your clients might encounter:
- Call options
A call option gives your clients the right to buy a stock at the strike price. This can be useful if they think the stock price will go up. If the stock price rises above the strike price, your clients can buy the stock at a lower price. Then, they can sell it at a higher market price, making a profit after accounting for the premium paid.
However, if the stock price stays the same or drops, the option might expire worthless. If that happens, your clients will lose the premium paid. - Put options
As for put options, these give your clients the right to sell a stock at the strike price before the expiration date. Again, your clients pay a premium for this right. A put option is beneficial if your clients think that the stock price will go down. If the stock price falls below the strike price, your clients can sell the stock at the higher strike price, even though the market price is lower.
If the stock price stays flat or rises, the option might end up worthless, resulting in a loss of the premium for your client.
Option writer
The person who sells the option is called the writer. The writer receives a premium from the buyer in exchange for taking on the obligation to buy or sell the stock if the option is exercised.
Writers of call options have the obligation to sell the stock at the strike price if the buyer exercises the option. In the same manner, writers of put options have the obligation to buy the stock at the strike price if the buyer exercises the option.
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Options trading can be useful in a bear market, which is characterized by falling stock prices. In such conditions, investors often use options strategies (such as buying put options) to profit from or protect against declining prices.
Risks in options trading
Here are some pitfalls that you should know:
- If the stock price never reaches the strike price, and your clients can’t sell the option before it expires, they lose the entire premium paid. That’s a total loss, which is rare with regular stocks.
- Options stack volatility on top of volatility. The price of an option depends on how much the stock moves and how much investors expect it to move. If volatility drops, the option’s value can fall sharply, even if the stock price doesn’t change.
- Options are time sensitive. Unlike stocks, which your clients can hold indefinitely, options lose value as expiration approaches. If the stock doesn’t move quickly enough, the option’s value can drop fast.
- Liquidity is not guaranteed. Some options are hard to buy or sell. Your clients might have to accept a lower price or hold the contract until it expires, which can lead to losses.
Why do people use options?
Options can be a powerful addition to your clients’ investment strategies. Here are some reasons why:
- Leverage: Options let your clients control more shares with less capital. For example, buying two call contracts is usually cheaper than buying 200 shares outright. If the stock moves in the right direction, the percentage gain on the option can be much higher than on the stock itself.
- Hedging: If your clients own shares and are worried about a price drop, buying a put option can set a price floor. If the stock falls, they can still sell at the higher strike price. This can help limit losses in a downturn.
- Alternative strategies: Options offer flexibility. Your clients can use them to benefit from price movements, volatility, or even time decay. For example, if your clients expect a stock to stay flat, they might use options to earn premium income rather than just holding the stock.
- Registered accounts: In Canada, shorting stocks is not allowed in registered accounts such as Registered Retirement Savings Plans (RRSPs) or Tax-Free Savings Accounts (TFSAs). However, your clients can use put options to benefit from a price drop without breaking any rules.
Where option contracts get their value
The value of an option comes from two main sources:
- Intrinsic value
This is the difference between the stock’s current price and the strike price. For a call option, if the stock price is above the strike price, the option has intrinsic value.
As for a put option, if the stock price is below the strike price, the option has this value as well. If the option cannot be exercised for a profit, it has no intrinsic value. - Time value
This is the extra amount your clients pay for the possibility that the option will become profitable before it expires. The more time left until expiration, the higher the time value. This value decreases as the expiration date approaches, a process known as time decay or Theta.
Options that can be exercised for a profit are called “in the money” (ITM). Options that cannot be exercised for a profit are “out of the money” (OTM). ITM options have intrinsic value, while OTM options only have time value.
What happens after your clients buy an option?
After buying an option, your clients have several choices:
- Sell the option: If the market moves in their favor, the value of the option might increase. Your clients can sell the option for a profit before expiration.
- Hold until expiration: If the option is in the money at expiration, it will usually be exercised automatically if your clients have enough funds or shares in their account.
- Let it expire: If the option is out of the money at expiration, it becomes worthless, and your clients lose the premium paid.
The price your clients can sell the option for depends on these three:
- current price of the underlying stock
- time left until expiration
- volatility of the stock
When your clients buy an option, they have the right to exercise it. Exercising means using the right to buy (for calls) or sell (for puts) the underlying stock at the strike price. If your clients exercise a call, they buy the stock at the strike price. If they exercise a put, they sell the stock at the strike price.
Assignment
Assignment happens when the writer of the option is required to fulfill their obligation. If your clients wrote a call and it is exercised, they have to sell the stock at the strike price. If they wrote a put and it is exercised, they have to buy the stock at the strike price.
Most options are not exercised. Instead, they are sold before expiration or expire worthless. Your clients might sell their options to lock in a profit, limit a loss, or avoid assignment.
Helping investors get more from options
Options can be a valuable addition to your clients’ investment strategies. They offer flexibility and ways to manage risk that stocks alone cannot provide. However, options are also more complex and can carry higher risks. That's why you must help your clients see what options can achieve and what the potential downsides are.
When used thoughtfully, options can help investors pursue their goals in ways that fit their needs and risk tolerance. And if you want to be a credible financial advisor, stay up to date with options market trends and always put your clients’ interests first. This way, you can help them get the most out of what options have to offer.
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