When most people hear about “stock options”, they tend to think of corporations awarding high-ranking employees with shares in the company, as a special form of compensation. However, in the investing world, there is a distinctly different form of option available: equity options. Let’s take a brief review of what equity options are and how they can be used to earn income and generate consistent returns.
First, let’s define equities. Equities are any instrument that represents ownership in an item of value. Equity can be something such as the value of your home less what you continue to owe on a mortgage or the amount of money you have paid into a life insurance policy. Ownership of shares of financial instruments, such as stock or mutual funds, are perhaps the best known and most popular forms of equities.
Equities differ from debt instruments, such as bonds or notes, which represent money owed to lienholders. There are several benefits to owning equities as opposed to debt instruments, but perhaps the most important one is the potential for gain. When a person owns a debt instrument (for example, a bond with a fixed interest rate), the return will be fixed (specifically, the return of principal plus the interest earned over the maturation of the bond). When a person owns equity (such as shares of stock), the value of the equity can theoretically appreciate to an unlimited extent. Therefore, many investors who choose to invest in equities over debt do so with the expectation that they will see a greater return with equities.
Shares of common stock that are publicly traded on stock exchanges are probably the most well-known type of equity to the general public. There are also derivative securities that can be traded that derive their value from the common stock. Exchange-traded equity options are one of the most prominent types of derivative instruments.
Equity options (frequently referred to as “listed options” when they are linked to an underlying stock and traded on an exchange) are a contract between two parties, a buyer and a seller. The buyer who purchases the option has the right (but not the obligation) to buy a quantity of shares of the underlying asset (typically stock) for a specified price (the “strike price”) on or before a specified date (the “expiration date”). The buyer pays the seller of the equity option cash (the “premium”) in order to hold the contract. On or before the expiration date, the buyer can choose to either exercise his/her rights to purchase the shares at the strike price or can simply choose to do nothing and allow the option to expire.
Equity options are frequently known as Listed Options or Exchange-Traded Options. This is due to the fact that equity options are traded on exchanges (such as the Chicago Board of Exchange) and are cleared through a clearinghouse (such as the Options Clearing Corporation) which guarantees the contract.
There are two types of equity options, call options and put options. Call options give the buyer the right, but not the obligation, to purchase shares at the stated strike price. Put options, conversely, give the buyer the right, but not the obligation to sell shares at the stated strike price.
Listed options differ significantly from the popular idea of “stock options” as representing shares of stock gifted as compensation. These stock options paid by a company to its employees are very different from exchange-traded options. These options often have vesting periods and distant expiration dates. It is also common for them to give employees access to shares at prices well below their market price. Employees owning stock options cannot trade them on an exchange.
A buyer would buy a call option in order to take advantage of a possible rise in the price of the underlying stock. The buyer pays the seller of the option a premium, and if the price of the underlying stock has risen significantly by the expiration date, the buyer can exercise the option to purchase the shares at a price that is below the current market price. If the price of the underlying has not risen by the expiration date, the buyer can decide to let the option expire, and will only lose the premium they paid for the option.
On the other hand, a buyer would buy a put option to potentially protect a gain on shares of stock they already own. If a buyer owns stock that has already significantly appreciated in value, they can buy a put option at a strike price at or near the current market price for the option. If the price of the underlying has dropped by the expiration date, the buyer can exercise the put and sell their shares for a price that is higher than the current market price, preserving their gain. If the price has not dropped by expiration, the buyer can allow the option to expire, and once again will have only lost the premium they paid for the option.
Equity options can also be used by sellers to earn income. A person who owns shares of a stock can sell a call option at a strike price that is above the cost basis for the shares. If the call option is exercised by the buyer, the seller will have the shares sold at this higher price, thus making a capital gain in addition to the premium they received from the buyer. If the buyer chooses not to exercise the option, the seller will still own the shares and will keep the premium they received.
Nearly all investors can trade equity options at their broker. They represent a very useful tool for investors to generate profitable returns for an account. It is easy for beginners to confuse exchange-traded options with stock options. They have some similarities, but listed options are much more accessible to all investors.Posted in Options and Options Trading |