2022 has lasted at least 15 months, right? 

As if this year has not brought us enough, we are into November, which means year-end and holiday plans start to form. Especially since this is the first year-end in a while where COVID is less of a consideration, decisions about where you’ll be and with whom start to be discussed. And of course, the anxiety of it comes with. 

I had to make restaurant reservations the other day and found myself using all the apps to keep my options open. I reserved both the good restaurant at the OK time and the OK restaurant at the perfect time to avoid the anxiety of making a decision just yet. They both charge something if you don’t cancel in time — so there is money at stake and a timeline.

You could say I have call options on both. Because, in investing, that’s essentially what a call option is: the right to buy something. 

With that in mind, let’s review just some of the concepts about investing in options. I’m just going to focus on buying calls and puts here, but note options are a multifaceted financial product that can be used for many strategies. There’s also a lot of specific terms used with them — it’s sort of a language that once understood means you’ll get the concepts easier. So best to do your homework. Above all, this is not a recommendation to invest in them. 

OK, let’s do this.

The concept of buying and selling stocks is easy enough. You buy a stock because you believe in the company and expect the price to go up. You sell it to either take profits or because you think the price will go down. Buying options on stocks is another way to profit on the movement of a stock (or in trader lingo, “the underlying”).

Buying a call option on a stock gives the buyer the right (but not the obligation) to buy 100 shares of that stock at a specified price (referred to as the strike price) by a specific date (called the expiration). In exchange for the right to buy this stock, the buyer pays what’s called a premium to the option seller. Generally, an investor buys a call option because they expect the price of the stock to go up.

Why is it named a call? Because the buyer of the option can “call” the shares of the stock if they decide to exercise the option. 

Let’s look at a quick hypothetical example to explain some more:

• XYZ stock is currently valued at $50 per share. 

• You buy a call option on XYZ stock for $5 (remember, because an options contract is for 100 shares, you’d pay a total of $500). Let’s say this call option gives you the right to buy XYZ at $52 per share (that’s the strike price) between now and the end of the year (the expiration date). 

• Now let’s say 30 days later, XYZ jumps up to $60 per share. This is good news for you, because it means you can either:

  1. Exercise your option to buy 100 shares of the stock at $52 and sell it right away for $60 

  2. Sell your call option, which will likely have increased in value. Given that this contract gives its owner the right to buy a stock that’s trading at $60 for only $52, the option is most likely worth more than the $5 premium you paid for it.

• Since the stock went up by $8, would your profit be $8 per share? Yes and no. It would, assuming you exercised your option then sold the underlying shares in the market for $60. But, keep in mind you paid $5 for the option. So you would actually gain a total of $3 per share ($60 - $52 - $5 = $3). 

• Because you only paid $5 per share in this example, that’s a pretty good return of 60%! 

Of course, if XYZ had stayed at $50 or even gone down through the end of the year, the option would likely have expired worthless. So, you would have been out the $5 per share (a $500 loss or -100% return). 

Let’s keep going.

The opposite of a call option is a put option. A put option gives a buyer of it the right to sell the underlying stock at a certain price by a certain date. Investors generally buy put options when they expect the price of a stock to go down.

So in our XYZ example above, where the stock went from $50 to $60, the holder of a $52 strike put option would have lost the premium they paid for the put option (it didn’t go down), if it remained there at expiration. BUT, if the stock goes down, to say $40, and you paid $5 per share for a put option with a strike of $48, then you would make $3 ($48 strike - $40 stock price - $5 premium paid = $3), assuming you own 100 shares of the underlying stock to sell.

Why is it named a put? Because the holder of the option can “put” the shares of the stock to someone else if they decide to exercise the option.

So to summarize, if you think a stock or ETF is likely to go up, buying the stock or a call option are two ways to express that. If you think it will go down, then selling it, if you hold it, or buying a put option on it, would be ways to express that view. 

Now, you may have started to pick up on this, but like making restaurant reservations, there a number of things that can impact the value of options (no, not the number of people):

• The current price of the underlying stock vs. the strike price of the option. How far apart they are will impact how much or little the option is worth. The term “moneyness” refers to that difference. 

  • A call option is “in the money” when the strike price is lower than the stock’s current price. For example, a $52 call option on a stock that’s currently trading at $60 is considered in the money. 

  • A call option is “out of the money” when the strike price is above the stock’s current price (e.g., when XYZ stock was at $50 and the strike price was $52). 

  • An option is at the money when the strike price = the current stock price. 

• The time to expiration. Remember above I said there was an expiration date? All options have this. The longer the time to the expiration date, the greater the “time value”, which impacts the price. The direction actually depends on moneyness (see point above) but it usually adds value if you hold the option, all else equal. 

• Volatility. This refers to how much the underlying stock can move in either direction. The greater the swings can be, the higher the volatility. And the higher this is, the greater the value of the option, generally speaking (all else equal). It’s not just the swings of the stock’s values in the past, but also expected swings in the future (this latter version is called implied volatility).  

While other factors like interest rates and dividends can affect an option’s price, the one I want to focus on is volatility. That’s because it can throw an investor off when it comes to the pricing of an option. Generally speaking, the higher the volatility, the higher the cost of an option (premium). 

In my time, I’ve seen investors decide they want to buy a put after prices have already fallen. Typically by this time, volatility has already increased, so the cost is higher, even if the other two factors, moneyness and time, didn’t change much. 

I liken this concept to buying flood insurance after a storm. It’s probable insurance was less expensive before you needed it vs. after. This is important to understand in a year like this one. The markets have already reached bear status (fallen from recent highs by 20% or more). While there are many reasons to buy puts (and call options), such as hedging a position or a whole portfolio, if you buy one, you have to believe the markets can go down further after already falling a lot. And by more than the premium paid for the put, which tends to be higher in more volatile markets.

Options, in essence, are a lot about probabilities.

For some context on volatility in history, here is a chart of the CBOE Volatility Index (VIX) going back to 1990. It measures market expectation of near term volatility conveyed by the prices of S&P 500 index options. When the VIX is high, it generally means the demand for options is high.

You can see current levels on the right, and are elevated.

Like you might do before making a restaurant reservation, spending some time reading about options, reviewing prices and the menu of what’s available is generally time well spent. It’s bound to make anyone a better investor (and diner).

Want to learn more about investing with options? We got you covered here. 

Source: CBOE

Chart: Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS, November 6, 2022.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Robinhood Financial does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.