So you have a lot of money, and you want to invest some of it. You’ve heard about options trading online and the big bucks you can make or lose on them. But what are they? How do they work? And why will listed options be riskier than just buying regular old options?
What are Stock Options?
Stock options are an agreement between two people: the “holder”, who has bought one of those options, and the “writer”, who has sold one of those options (i.e., who has promised to buy or sell shares). The holder gets the right but is not obligated to buy or sell several shares as stated in their agreement.
Buying an Option
When you buy an option, you expect everything to go up. You are paying money for this expectation, so naturally, you’d love it to come true. If it does come true, then your option will be worth a lot (and if the stock goes down in value, well, what did you expect when you bought that option?).
The writer of an option would much prefer that nothing happen; they get paid in return for this “promise” since obviously, they can’t get that money back unless something happens with the stock prices (in which case they make money). But when people buy options like crazy, and prices are high (or expected to rise), the writers might run scared because they know there’s good money to be made by assuming that the prices will come back down. So they can play hardball. If you’re not careful, this can kill your profits pretty fast.
Let’s Look at an Example of Buying Options:
XYZ company has just announced fantastic earnings results, and their stock price is rising sharply.
A call option is bought by you for 100 shares at $5 each, giving you the right to buy those 100 shares in one month for $5 per share no matter what the current market price is (most people would advise you not to do this since we already know there’s going to be a good rise in the value of XYZ… but we’ll keep it simple). The total cost? $500 ($5 per share times 100 shares).
The stock price rises sharply to $15, so the option you bought for $5 is now worth $1,500 (you can buy it for $1,500 and immediately sell it at market value – there’s no need to wait to use it). You sell your option. You’ve made a nice quick profit of $1,000 minus commission/fees ($1500 less the $500 cost of buying the options).
People who write options don’t like this happening. They’re hoping that the rise in prices won’t be as dramatic as all that, or they’ll hope against hope that XYZ will fail spectacularly and things will go back down. After all, if people follow the price of XYZ, when they can see that their option is suddenly worth $1,500, the writers will be forced to follow and not risk angering all those buyers. This sort of thing often happens in options: the writers only sell when people are desperate for options and prices are high (and sometimes they price them very high to avoid taking on too much risk).
It brings us back to the listed options. Listed options have already been sold – a bunch of them. The sellers profit from selling these options, so they don’t want prices to go up anymore. If you buy an option from someone who has already made some money off it, then you’re going to get a worse deal because you’ll have to pay more.
If prices are rising, the writers will want more money for their options because they’re not worth as much (if your option is worth an arm and a leg, you’ll only sell it for a prosthetic limb). If prices are falling, then the writers will want less because people will be desperate enough to buy them at any cost.