Taming the Complexity: Why Options Investing Has Always Eluded the Average Investor
Options have the reputation of being high-risk investments that only experts can understand...
Options have the reputation of being high-risk investments that only experts can understand. To get it straight, if they're misused, the consequences can be severe. However, once you cut through all the mystique and jargon, options can be a powerful investment tool. One that can carry a relatively low risk if you know how to use them properly.
What Is An Option
Options are derivatives, or contracts, that give the buyer the right, but not the obligation, to either buy (call options) or sell (put options) a fixed amount of the underlying asset for a specified price on or before the contract expires.
Benefits of Options
Options have been receiving a bad rap for many years. Whether through sections of the media, or individuals getting burned personally, people view them as risky and speculative. However, when used properly, options can provide advantages across a range of areas.
Options are a leveraged investment. Investors can control a number of shares similar to a regular investment, but with only a fraction of the outlay.
Investors Can Use Options to Reduce Risk
Options offer a more dependable way to hedge a position than other methods, such as a stop-loss order. A stop order will place shares on the market when the price drops to or below a certain level.
The problem stop orders face is that they can gap. You buy shares at $50.00 and decide you don't want to risk more than 10% of your capital. So you place a stop order at $45.00. After the market closes, there is massive news about your company. It opens the next morning at $25.00.The price has jumped your stop order. Your order will be triggered with the price at $25.00, you've lost 50%, and there is nothing you can do about it. Options, on the other hand, never sleep and are in effect 24/7.
Options Have the Potential of Higher Returns
The maths speak for themselves. If you invest less money and make a similar return, you are earning a higher effective interest rate. Of course, this can work against you as well, meaning options can amplify losses. Making the proper option choices is vital.
More Strategic Alternatives
The flexibility of options means investors can use them in many ways. You can use options to profit in rising, falling, and even stagnating markets.
Evaluating the Price of an Option
As with any investment, understanding, all the factors that will affect the price of your options is a vital component to success. For that, a firm grasp of the Greeks (Delta, Gamma, Theta, Vega, and Rho) is in order. Each represents a factor that will affect the value of an option and give you a framework to understand if you wish to make a particular investment.
Delta: The Hedge Ratio
Delta measures the impact changes in the underlying stock price has on the value of the option. A Delta of $0.40 means an option's price will change by $0.40 for every $1.00 that the value of the underlying asset changes. Call options have Deltas that range from 0.00 to 1.00. The Delta of an in-the-money call option will increase toward 1.00 as the contract expiry date approaches. An out-of-the-money call option will head toward 0.00 as contract expiry nears.
Gamma: The Rate of Change of Delta
Delta is a measure that only applies to a specific point in time. Gamma will let you know how much the Delta of an underlying asset should change as its price increases or decreases. Delta is the speed at any point time, and Gamma is the acceleration. If an option's Delta moves from $0.40 to $0.55, then its Gamma is 0.15. As the Delta approaches an absolute value (-1.00. 0.00 or 1.00), then the Gamma will decrease.
Theta: Time Erosion
Options have expiry dates, which will naturally affect their price. Options will lose value as the end date nears. Theta measures how much per day the value of an option will decrease if all other factors remain the same.
Vega: Sensitivity to Volatility
Vega measures the rate of change in an option's price per 1% change in the underlying asset's implied volatility. It will tell you how much the price should move when the underlying asset's volatility increases or decreases. An increase in Vega will cause options to gain value, while a reduction in Vega will lead to a loss in value. It is vital to take Vega into account when deciding on a particular option.
Rho: Sensitivity to interest rates
Rho measures an option's change in price per 1% change in U.S. Treasury-bills interest rates.
You can see that investing in options can get complicated quickly. Talk to us to find a new, simple way to cut through the complexity and harness the power of options.