Options: Answering the Call

So, how can someone invest across asset classes without having the capital to do so (e.g., buy the stock or ETF directly)?  The answer is the option market of ‘calls’.

A call option is a contract granting the buyer the right, but not the obligation, to purchase an underlying asset at a set strike price on or before a specific expiration date.  I can buy an option call when I believe the underlying asset price will increase. Conversely, I can sell an option call when I believe the underlying asset price will decrease. However, when I sell that call option, I must be prepared to part with the underlying asset. If I don’t have the asset, then I owe the equivalent additional money equivalent to the number of call options at that strike price.  It is important to note that 1 call option, the smallest increment you can buy or sell an option, represent 100 shares of the underlying asset.

What this means in practical terms, is that I can now get portfolio exposure to underlying assets, with only a fraction of the capital needed if I were to buy the asset directly.  To illustrate, imagine you have company whose stock is trading at 1,000 per share; the strike price today is $1,000.  To buy 100 share, you would need to have $1,000 x 100 or $100,000. However, you could buy one call option at a strike price of $1,000 in 120 days from today for $2,000.  I would then enjoy the incremental gains of the share price, the gains being amplified through the nature of the options market, while facing a potential loss not to exceed $2,000.  If the share price drops 20% from the time I buy the contract, I would lose $2,000. If I had bought the underlying stock, I would be down $20,000.  Moreover, if the stock gains value of say 20%, I would be looking at $20,000 in gains; but the option value is not linear and could in fact yield 2,000% based on the cost of the option, etc. So in the case of the option version, I could be realizing gains of $38,000 (i.e., 40,000 less the 2,000 cost of the option).  At which point I could sell the option and close the position, or take possession of the 100 shares at $1,000 each, at which point I would need $100,000 in capital.

It is through options that I have been able to get the desired exposures to asset classes that on the surface would have been out of my reach as young student.  As I grow my assets, I will buy more of the underlying assets when I can afford to do so. But I will also continue to use options as a way to enhance my portfolio return.  

For example, for stocks or ETF which I own 100 shares, I can sell call options. In other words, I can take a stock that trades today at $10, and sell a call option on it for $1 with a strike price of $11 in 90 days. If the stock goes to $11 in 90 days, then I will paid $11 x 100 and I will have collected by premium of $1 x 100 and end up with $1,110 as opposed to simply selling the stock at $11 and ending up with $1,100.  However, there is a downside. If the stock rips higher to $20, then I miss the 20-11 or $9 benefit as I committed already to sell the stock at $11.

A few other key terms necessary for call options:

• In the money (ITM): the stock price is above the strike price, giving the option intrinsic value.

• At the money (ATM): Stock price equals the strike price.

• Out of the money (OTM): Stock price is below the strike price. OTM options are worthless at expiration.

• Strike price: The price at which the asset can be bought.

• Expiration date: The date the contract becomes void.

• Premium: The cost paid for the option, representing the maximum loss for the buyer if the asset is covered; un-covered calls for virtually limitless losses and therefore carry extreme risk.

In summary, options can offer exposure to assets that otherwise would have been too expensive. This exposure is not linear to the underlying asset and can significantly amplify your losses and gains.  It is for this reason that I have made it a personal rule to not sell uncovered calls or calls to which I do not own the underlying asset already. The reason is that a ‘short squeeze’ situation can arise where the parties who sold the asset short (i.e., sold an uncovered call) are scrambling to buy the underlying asset to stop their losses. This short term need by many parties to buy the stock drives the price higher, amplifying the losses of the short seller. Hence the name, short squeeze.  Conversely, buying options can help drive the underlying asset price up as the brokerage selling the option has to buy the underlying asset to cover themselves in the future, leading to the price being bid up higher (i.e., in situations where large option calls are bought at a slightly higher price to today’s strike price, the price of the asset is often driven up in the short term, all else being equal).