What Are Options and Should I Invest In Them?

In the investing world, what are options?  Simply put, they are contracts that require the holder to buy or sell a certain stock at a certain price on a certain date.  For example, right now (Saturday morning, 12:03 CDT) the latest price for one share of AT&T is $34.86.  Via Robinhood, I can buy "Calls", which are options to buy AT&T at a certain price, or "Puts" which are options to sell AT&T at a certain price.  

Calls

One example is that  I can buy a Call that expires on March 29, 5 days from now, which allows me to purchase 100 shares of AT&T stock for $35.50 per share.  This call will cost me $15.00.  On March 29, if the market price for AT&T is above $35.64, and I still own that option, I make a profit.  I can use my option to buy the shares, and then almost immediately, to sell them (unless I want to own them, in which case I can keep them).  If the market price is below $35.64, I lose money, but my loss is capped at the $15.00 I invested.  In short, it is possible to lose 100% of my investment, but the dollar amount I risk can be less than if I purchased the stock outright.

I can also buy a Call that allows me to by 100 shares of AT&T at $37.00 on January 18, 2019.  That would cost me $132.00 In order for me to break even on this option, AT&T would have to go up to $38.32 on January 18, 2019.  If the market price is more than that, I make money; less than that, I lose money, but whereas my total gain is hypothetically unlimited, my downside is limited to $132.00.  

Once you own a Call, you can sell it at any time before it expires.  For example, if over the weekend AT&T announced that they had invented a super new type of internet bandwidth that was going to revolutionize everything, and investors reacted Monday morning by bidding up the price of AT&T to $50 a share, people would love to get their hands on my option to buy shares at $35.50, and they'd be willing to pay more for it than what I did. I can sell the option to someone else, and make a profit.  The price of call options tends to move in the same direction as the price of the stock.  

Puts 

Puts are the option to sell 100 share of stock for a certain price.  Right now I can buy a Put that expires March 29 to sell 100 shares of AT&T for $35.00 per share.  The cost of that Put is $59.00.  On March 29 if AT&T is worth more than $35.00 per share, I can buy 100 shares and then sell them immediately for more than I paid.  In order to make a profit (because I did pay for the Put), I need the price of AT&T to drop below $34.42.  With this Put the most I can lose is $59 (my investment) and the most I can gain is $3441 (assuming AT&T drops to zero).  

More long-term, I can buy a Put that expires January 18, 2019 for $348.00.  In this case, I make money if the price of AT&T drops below $31.52.  The most I can lose is the invested $348 and the most I can gain, assuming AT&T drops to zero, is $348.00

Like Calls, Puts can be sold at market rates, at any time before they expire.  The lower the price of the stock goes, the more valuable Put options become.  

But Why?

Why do options trade?  What is the point?  To make money of course.  If I own a stock and sell a call option on it, I collect the sale price.  Using the example above, if I had been the originator of that March 29 call option and it originated today, I would collect 15 cents per share for those one hundred shares.  At that point, two things could happen.  First, the stock could end up below $35.50, in which case I keep my fifteen cents and I can keep my stock or sell it at market price.  The other thing that could happen is that it sells for more than $35.00, in which case I have to sell it to the holder of the call for $35.00 per share.  Basically I say that in return for getting 15 cents per share now, I am willing to limit my upside.  If the stock goes through the roof, you are the one that gets the extra profit.

Please note however, that one I (the owner of the shares) sells you an option, you are free to sell it to others.  Selling to option to others does not obligate you to provide shares to the person who owns the option at expiration.  

Options allow investors who own stock to give up some possible profits in return for a known payment.  Options allow other investors to invest relatively small amounts of money and to possibly gain a lot.  Trading options--buying and selling the options only, and not owning the underlying stock, is a high-risk high-reward (and high loss) way of investing. 

How Do You Invest in Options?

Most brokerage houses allow options trading, though the SEC has more stringent requirements for trading options (which can and often do expire worthless) than for trading stocks.  While I have never traded options, my Robinhood account was just enabled for them.  I'm going to study the types of trades and the risks involved a while longer before investing.

If you would like to get a free share of stock, sign up with Robinhood, an online brokerage firm that charges no sales commissions.  If you sign up, we both get a free share of stock.