Nearly every day I see the online advertisements for options trading. These ads focus on the outrageous returns that can be achieved via options, which can easily be over 1000%. However, as with any investment, the greater the reward, the greater the risk. In fact, I would compare most options not to other investments, but to different table games played at the local casino. Today, we’ll show you how to make options a part of a sensible portfolio, instead of a gamble.

What is an option?

An option is the right to purchase or sell an underlying security at certain price at a future point in time. Here we will be discussing a call option, which Kevin has described very nicely in a post last week. Today we will be focusing on one option specifically, and the returns for good, bad, and mediocre scenarios.

Option Type: Call
Underlying Security: C – Citigroup
Strike Price: $4
Expiration: Jan 2013
Premium: $1.37

When purchasing an option there are a large number of variables to consider. Expiration date, strike price and underlying stocks volatility all have a huge impact on the premium paid for an option. Keep in mind that in general, the larger the potential returns, the larger the risk. For all of the scenarios below we have ignored trading fees to make the math simpler.

Underlying Stock Declines in Value

Let’s cover the seemingly worst scenario first because this represents the maximum amount of money you can lose on the option. If on the expiration date (Jan 2013) the stock is below $4, the options are worthless and you have lost your premium. You have lost 100% of your initial investment (plus trading fees).  On the bright side, you can now purchase the underlying stock at the much lower price.

Let’s assume C dropped to $2, the options would now be worthless. However, you can buy C stock in the open market for two dollars.  This means your cost basis for C stock would be $3.37 ($2 for the stock purchase plus $1.37 for the option premium that was lost). If you had purchased Citi stock today, the cost basis would be $4.70.

If the stock price drops enough, even though you lost 100% of your initial option premium (bad), you would still own C shares at a cheaper cost than if you purchased them today (good, if you still want that stock).

Underlying Stock Trades Sideways

Depending on how you look at it, this is potentially the worst scenario for an investor that uses options correctly.  Let’s assume C traded sideways and on the expiration date C traded at $4.50. It would be in your best interest to exercise these options in which case you are now the proud owner of C stock with a cost basis of $5.37 ($4 strike price for the stock purchase plus $1.37 for the option premium). That’s a loss of $0.87 per share. Not good.

Clearly in any sideways scenario (~$3.50 to ~$5.50), you would have been better off purchasing the stock outright without an options contract. Regardless, things are not all bad. While you will have lost some money, you won’t have lost 100% of your premium (like you would have in the first scenario). As long as you believe in the long term future of the company, you may still get a good return eventually.

Underlying Stock Increases in Value

These are the really exciting scenarios.  Let’s assume Citigroup reported great earnings, made good progress on their business strategy, and decided to start dividends or stock repurchase plan and their stock hit $8 by Jan 2013 (very bullish scenario, I know).  If you had purchased the common stock, you would now have a fabulous return of ~70%.  However, if you had purchased the options instead, you would now have an astonishing return of just under 200%.

In any scenarios where the underlying stock increases significantly in value, we see our returns multiplied through options.

Word of Warning

You Have Options

You have four arrows, but they only point in two directions. Honestly, call options give you way more options than this.

As mentioned before, there are almost infinite options when it comes to options (pun intended). For example, if we chose a different strike price ($5.5), we could have increased our returns to 300% (but our risk would have increased as well). If we chose a different strike price ($5.5) and a different expiration date (Jan 2012), we could have increased our returns to 700% (but our risk would have increased as well). Make sure you carefully calculate the risk/reward level you are comfortable with and be prepared to lose it all.

Option Expiration

On the expiration date, you broker will automatically purchase 100 shares for each option contract on your behalf, so make sure you have the appropriate funds in your account.  The easy way around this, is to sell the option at any time before option expiration.  If the underlying security is trading below strike price, this is a moot point as the options will just expire.

Alternatives:

You can purchase options on nearly any security.  However, be aware that these carry a significantly larger risk than the common stock and that the pricing is often very difficult to calculate.

Disclosure:

I have a long position in C.

Kevin’s Take:

As I mentioned last week, I have been trading options in Citi for a while. I am still holding some options and plan to buy more soon. The Hoff didn’t talk much about why he picked Citi over any other stock. Of all the banks in the world, I believe Citi is best positioned to capitalize on emerging markets growth because of their massive global presence. This alone make them a very attractive investment in my opinion.

If you don’t know much about options and you are still confused, post a comment and if there’s enough demand I’ll work on a video explaining it better.

Important to note that ALL ideas, thoughts, and/or forecasts expressed or implied herein are for informational and entertainment purposes only and should NOT be construed as a recommendation to invest, trade, or speculate in the markets.