What if I told you that you could get the benefit of owning $10,000 worth of stock, but only had to put $1,000 of your wealth at risk…
That sounds like a good arrangement, right?
When you buy an options contract, you can use less of your capital while potentially booking more profit than if you bought the same dollar amount of stock shares.
This is an example of financial leverage, which allows you to generate higher percentage gains with less money.
And when used correctly, financial leverage can help you accumulate profits quickly!
Financial leverage also comes with extra risk.
And you should always make sure you understand those risks before putting money you can’t afford to lose into any options play.
Today, I wanted to continue our series on options by explaining how option prices move and showing you the potential rewards (and risks) from these investment tools.
What Is an Options Contract Really Worth?
As we covered in yesterday’s installment, options contracts are agreements that give you the right to buy or sell shares of stock.
A call contract gives you the right to buy 100 shares of stock at an agreed-upon price. And a put contract gives you the right to sell 100 shares of stock.
These contracts trade on exchanges just like shares of stock.
And the price you’ll pay for these contracts depends on the perceived value — or what investors expect the value of the contracts to be.
There are a couple of different components that determine the price of an options contract.
And when you understand these components, you’ll be able to make better decisions about which options contracts to use for your personal investment style.
Let’s start by thinking about how much an options contract would be worth if you were to exercise your right to buy or sell shares right now.
Using our example of Apple Inc. (AAPL) $135 call contracts from yesterday’s installment, think about how much that right to buy shares of AAPL would be worth if the stock were trading at $175.
If you could buy shares at $135 and immediately turn around and sell them in the market at $175, that value would be worth $40 per share.
This is called the intrinsic value of an options contract. But it’s only part of the story.
If you owned an AAPL $135 call contract that didn’t expire for another three months, you should be willing to pay more than just $40 per share.
After all, you’re getting the right to buy shares of AAPL for $135, and the stock could continue trading higher.
So with three months left to go, the potential for AAPL to trade higher would make you willing to pay a bit more for the option.
So maybe instead of paying $40 per share, you would be willing to pay something closer to $50. That extra $10 on top of the intrinsic value is known as extrinsic value or the time value of an option contract.
Tracking the Price of Your Call or Put Contracts
When you own a call contract and the price of the underlying stock trades higher, the market price for your contract should also trade higher.
That’s because the intrinsic value will naturally increase.
Let’s go back to the example of the AAPL $135 call contract.
If shares of AAPL moved to $175, the intrinsic value would be $40. And if AAPL traded even higher up to $185, the intrinsic value would be $50.
As you can see, a small percentage increase for a stock price can lead to much bigger percentage gains for your option contract.
In the example above, a 5.7% increase for shares of AAPL would have led to a 25% increase in the intrinsic value of the option price.
Put contracts work the opposite way.
If you own a put contract, it gives you the right to sell 100 shares of stock at a specific price.
Let’s imagine you own a put contract that lets you sell 100 shares of Netflix Inc. (NFLX) for $580.
If shares of NFLX are trading at $550 right now, that put contract would have an intrinsic value of $30.
After all, if you could buy shares in the market right now at $550 and use your put contract to sell these same shares at $580, that contract would be worth at least $30 to you!
As shares of the stock move lower, your put contract becomes more valuable.
For example, a 9.1% move lower for NFLX would leave the stock trading at $500. And if shares of NFLX were to trade at $500, your $580 put contract would be worth at least $80 per share.
That’s because having the ability to sell shares at $580 when the stock is trading at $500 gives you the ability to immediately turn an $80 profit.
Since investors can buy an options contract and then sell it in the market rather than exercising the right the contract represents, many short-term traders use options to speculate on movements in stock prices.
These traders buy call contracts when they expect stocks to trade higher, and they buy put contracts when they expect stocks to trade lower.
Always Be Aware of Time Decay
One of the most challenging things about buying options contracts to speculate on stocks is the fact that every contract has an expiration date.
When the expiration date passes, the contract is no longer valid. So there’s a clock ticking every time you purchase one of these options contracts.
Remember the time value part of the option’s price we talked about a minute ago?
Well, that extra value for every options contract you buy diminishes slowly as time passes and you get closer to the options contract’s expiration date.
Traders call this erosion time decay because over time, the price of your option contract will slowly decay.
You’ll notice that when you look at different options contracts for the same stock, contracts with a lot more time left are almost always more expensive than short-term contracts.
Always keep that in mind when buying put or call contracts.
Over time, these trades slowly lose value. So it’s usually better to use options contracts for short-term plays instead of viewing them as long-term investments.
Limited Risk, But Don’t Bet the Farm
The final thing you need to remember when buying options contracts is that every dollar you invest in an options contract could be at risk.
Think about the example of our AAPL $135 call contracts.
If AAPL trades lower before the options contract expires and eventually moves below $135, the call contracts would eventually be worthless.
After all, there’s no reason to pay for the right to buy AAPL at $135 if you can buy the shares in the open market for $130.
So while it’s very rare to lose all of the money you invest in the stock of a legitimate company, losing the full amount invested in an options contract is pretty common.
There’s a trade-off in this situation.
An AAPL call contract could allow you to spend less of your capital to control a larger dollar amount of AAPL shares.
But at the same time, you could potentially lose all of the money you invested in that call contract.
You have the potential for a much higher percentage return on the money you use for your call contract. But you also have the potential to lose 100% of the money you put into this play.
For this reason, if you’re going to buy options contracts to profit from stock movements, it’s wise to use a much smaller percentage of your retirement wealth for each position that you take.
That way, if your trade works out the way you expect, you’ll be able to lock in some very attractive profits.
But if the position doesn’t turn out as well as you hoped, you won’t be risking too much in any one play.
That’s it for today.
In our next installment, I’ll be turning the tables around and showing you how to take less risk with options and generate reliable income with these versatile tools.