Explore your Options - Part One

Peter Katevatis - Jun 04, 2015
As the old saying goes "keep your options open".  When buying a car, one of the main perks of a new vehicle is the options.  We all put a different value on certain options (leather seats, DVD player, navigation, bling tires, etc).  For my wife, it i

As the old saying goes "keep your options open".  When buying a car, one of the main perks of a new vehicle is the options.  We all put a different value on certain options (leather seats, DVD player, navigation, bling tires, etc).  For my wife, it is heated seats – it has to be an option presented when buying a car; throw in a heated steering wheel and the forms are signed in seconds.

 

KWM Seat Heater

 

We all like options, but sometimes they can be overwhelming when there are too many.  It can also be overwhelming when the quantity is too high or too complicated.  I find this particularily prevalent when talking about options and derivatives in the equity market with clients.  This is the first of a three part blog series to help you understand equity options & derivatives, also known as Puts & Calls and various options investment strategies.

 

Options can provide many effects with complex outcomes but at their root it is a way to invest in a time specific outcome.  I will start with the basic Call option.  If you buy a call option, it gives you the right to buy a security at a set price (called a strike or exercise price) up to a certain date.

 

For example:

  • You would like to buy 100 shares of XIU. Shares are currently trading at $22.18
  • You would like to pay only $22.00 per share – this is your strike price (or exercise price)
  • You buy a July call option on XIU for $450.00 with the right to buy 100 shares at $22.00
  • Date of call option – now through to July 18th, 2015

 

Regardless of what price XIU shares are trading during this time frame, you have the option to buy your 100 shares at $22 per share.  With this investment strategy, you are speculating bullishly that the shares will rise well over $22.00 giving you a great deal on your 100 XIU shares.

 

Sounds good right? Why wouldn’t I buy a call option for $0.45 per share to get the shares at a discount? But is it a good deal?  Generally, no.  There is a slight premium you are paying for the privilege of holding the right to buy.  Most call options expire without ever being exercised.  In the case above, you would have spent $450 and still not have shares of XIU if the shares are trading below $22.45 (cost of option plus shares) on expiry date.

 

In options investing, you can also be a seller which is a way to capitalize on the premium other investors are willing to pay.  The main driver of this changing premium is volatility which is heavily influenced by the volatility index (VIXC).

 

In total there are 6 factors that affect the price of the option, they are:

  1. Stock Price – the movement in the underlying security
  2. Strike Price – the price you can buy (or sell) the underlying security
  3. Volatility – the propensity for the shares to go up and down
  4. Time – the date the options expire
  5. Dividends – the amount of dividends the underlying security pay
  6. Risk free rate of interest – the opportunity cost of sitting on cash

 

Please contact a professional to learn more or wait for my next posts that will explain derivatives in more detail.