The basics of options: What they are, what they do and how investors use them

In my recent story about “zero days to expiration” options, I focused primarily on the danger of this risky part of the market. But the piece generated a lot of member questions about options in general — what they are, how they work and how regular investors use them — so, we’ve decided to take a deeper look at the world of options. For starters, options aren’t assets. They are derivative instruments that can be used to speculate on underlying stocks or to hedge existing positions. You aren’t investing in a company, you are betting on the direction, timing and magnitude of the move in a given security. The counterparty is taking the opposite bet, believing that one or all of those factors will not pan out as expected. It’s also crucial to recognize that options contracts are a zero-sum game. The profit for one party equals the loss of the counterparty. They have the potential to mitigate risk and enhance returns. They can also blow up your portfolio virtually overnight. Imagine options as a hammer: It can build a house or break one down, depending on how it’s used. Consider this ripped-from-the-headlines, hypothetical scenario on Apple (AAPL), which is one of our two “own it, don’t it” Club stocks. Pretend, for this example, Apple is hosting an event with investors in two weeks. While the company hasn’t disclosed the agenda, some analysts expect a new product will be announced that could be a real game-changer — and a catalyst for shares of Apple to jump. You’re thinking: Buy shares now and catch the expected move higher. But what if the analysts are wrong, and Apple doesn’t reveal a new product? Or it does announce something new, but the market isn’t terribly excited about its growth potential? Now you have a catalyst for shares to slump as investors sell their stock during and after the meeting. If you bought shares two weeks ago, you are now sitting on losses. As an investor, here are three choices you could make: Do nothing; accept the risk and buy Apple prior to the meeting; or buy a call option. The first two are self-explanatory. The third choice? Not so much. Call option Rather than buying 100 shares of Apple at $180 each for a total of $18,000, you use an options contract. A single options contract always represents 100 shares. (Of course, you can buy as many contracts as are available if you want.) This will allow you a chance to get in on any gain in Apple stock without spending $18,000 upfront. You turn to your online brokerage (which acts as a middleman) and check the “option chain,” which lists all the available contracts. For example, you might find one with these kind of characteristics: Days to expiration: 30 days Strike price: $183 per Apple share Premium: $2 per share By purchasing this call options contract, you now have the right — but not the obligation — to buy 100 shares of Apple at $183 per share within the next 30 days. For this right, you will pay a premium of $2 per share (or $200 per contract) upfront to the counterparty. In this scenario, the most you can lose — if you do not end up purchasing shares — is this premium of $200. Your break-even price is $185 per share (see chart below) — the strike price plus the premium. So with a call option, you get upside exposure with defined downside risk that is limited to the option premium. You also do not need to tie up the full cost of the underlying position. Lastly, there is immense leverage built into the contract, despite there being zero need to borrow money. Quantifying the leverage in this case: If you bought the Apple stock at $180 and shares rose to $187, you would realize a 3.9% return — your $18,000 investment would appreciate to $18,700 in total value. However, with an option, you would make 100%, or double, your money because the contract you paid $2- per-share for is now worth $4 per share (the amount above the strike price of $183). So, your $200 “investment” (the premium to buy the options contract) nets you a $200 profit. If Apple stock never gets to $183, the contract expires as worthless and the counterparty keeps your $200. Anything between the strike price and the breakeven and you are losing some money, how much will be determined by how far away you are from the breakeven level. Put option A put option works in the other direction: Instead of buying the right to purchase shares, buyers have the right to sell shares at a given strike price by a given date. For an upfront premium, the buyer ensures he will not take losses beyond a specified amount. You are covered for all losses beyond the strike price with the break-even being the strike price, less the option contract premium. If shares never reach the strike price, you lose your premium and the protection ultimately expires. And again, if shares trade to a level between the strike price and the breakeven price, you lose some money, the amount is determined by how far away you are from the breakeven level. Let’s again use the hypothetical Apple example. The strike price of $183, a $2 premium and 30 days to expiration. Once Apple shares fall below $183, you are “in the money,” meaning you can buy shares under the $183 strike level in the open market and sell them to the person who sold you the put option at $183 apiece. In this instance, your break-even is $181 per share because if you buy shares in the open market at $181 and sell them to the counterparty (the put seller) at $183, you make $2 per share, just enough to cover the upfront cost of the contract. If shares were to go to $179, then you would make the same 100% profit as in the call option scenario above. Lastly, say shares fall to $181.50, you lose 50 cents per share (or $50 on the contract) because you are still 50 cents away from hitting that breakeven level. In both scenarios above, you are considered to be “long” the option. That means you purchased the option for the right to either buy or sell shares at a given price. The most you can lose is what you paid upfront, the premium. This is not the case for the counterparty in the Apple example. The risk of loss when shorting an option — meaning you sold a call option or a put option contract to someone else — can be much greater. Anyone can sell an options contract, just as anyone can buy one, but the risk/reward profile differs significantly and it is critical that traders fully understand the obligation they are taking on when selling (or shorting) in the options market. The other side of the contract Let’s work from the examples above. For simplicity’s sake, let’s just assume that the options you purchased above, were sold by me, Zev Fima, the guy up there in the byline. For the call option, I’ve taken your $200 at initiation. I am potentially on the hook to deliver 100 shares of Apple to you at $183 apiece. We will assume that I am “naked” in my position, meaning I do not already own any shares of Apple at the time of the contract purchase that I can deliver to you if needed. I will instead need to go purchase shares in the open market, at the market price, should you call on them – see what I did there, owning a call option allows you to “call upon shares” whereas owning a put option allows you to “put shares to someone else.” If shares do not hit or exceed that $183 strike price, I’ve made a cool $200 and we part ways. However, if shares do reach that level, I have to provide them to you for $183. If shares are trading at $184, then I have to go buy them at $184 and sell them to you for $183. That’s a $100 loss that is more than offset by the $200 premium, so I’m still up $100 in total (and you are down $100 or $1 per share). At $185, we both break even as you get shares at $183 plus the $200 premium you spent, and I take a $200 loss (buying in the open market at $185 and selling to you at $183) offset by the $200 premium I took initially. Above $185 and I’m now losing, and you’re winning. In this scenario, my potential losses as the counterparty could be huge – in theory, the max loss is infinite. No matter how high Apple shares go, I must deliver them at $183 to you as is your right and my obligation. If we go into a 2000-like tech bubble mania and shares explode to $1,000 apiece, I’m in trouble. I still owe you 100 shares at $183 apiece, so I have to come up with 100 shares ($100,000 at $1,000 apiece) to deliver to you. For this reason, a “naked” short on a call option is arguably the single most risky trade that can be made in the options market. Consider that my max upside was keeping your $200 premium. Funny enough, had I already owned 100 shares of Apple when I sold you the call, the trade would be considered a “covered call,” what many considered to be the single safest trade that can be made in the options market. The reason: If I already own the shares, then I am simply selling you my upside. If shares skyrocket to $1,000, I missed the entire move since I sold my upside (in this case for $200), but at least I don’t need to chase that move and come up with the cash to buy the shares at $1,000 apiece. It’s like selling a winner too early, it hurts but it’s not the end of the world as missing the upside isn’t the same as losing money. Selling a put option essentially puts you in the shoes of an insurer. For an upfront cost (the premium) you are agreeing to take on any and all losses beyond a certain point (the strike) price. So if I sold you that put option with a $183 strike, I agreed to purchase shares of Apple from you at $183 apiece. If Apple went bankrupt tomorrow and your shares were worthless, it doesn’t matter: I am still on the hook to buy them from you for $183. My losses (and your gains) are partially offset by the premium you’ve already paid me. So, for both of us, the break-even is $181 — the $183 I am paying you for shares offset by the $2 you paid me to initiate the put option contract. This is a risky move but not nearly as risky as selling a naked call because stocks stop at $0 and max loss is therefore defined, there is, on the other hand, theoretically no limit to the upside How to trade Options can be purchased for individual equities or broad-based market indices – they’re also available on a slew of other securities outside the equity market. Often shares are never actually traded as traders will look to close out the contract prior to the expiration date and settle up in cash. If you are long the Apple call noted above and shares move to $187, meaning the option you paid me $2 per share for is now worth $4, you sell the contract back to me for $4 per share ($400 total), rather than having you actually buy $18,300 worth of the Apple stock from me (the $183 strike multiplied by 100 shares). This is also why investors with smaller accounts may be interested in options. You can leverage large notional amounts without ever needing the funds to actually take delivery. You can close out the contract and settle up in cash. Options based on an index are always settled in cash. It’s also important to understand that you can trade options without actually taking a position in the underlying security. You don’t have to own the underlying security to purchase a put option. In this way, the put option acts more like a short position in a stock rather than insurance for an existing position. You can also have multiple “legs” to an option position, creating various risk/reward profiles based on the outcome you think is most likely or the possible event you are trying to hedge against. We will look to dig more into this in the future. But for now, it’s important to understand the mechanics of how calls and puts work and the risk and reward profile of being long or short these contracts over a period of time. Most importantly, being short the options contract — the option seller — can result in losses far in excess of the premium put up for a call option or a put option by the buyer of the contract. Being long an option on the other hand means that the most you can lose is your premium. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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