What you need to know about options
People will debate which other stocks could go as viral as this one did, or whether the market is dramatically altered in some way as a result, but I don’t think it is; the little guys are not the new Wall Street kings and the big firms will continue to do just fine, for better or for worse.
There is one thing, though, that’s come out of this saga that could have more lasting consequences on the broader retail market: the increasing use of options. Much of the GameStop activity was driven by option buy and selling, while last year, for the first time ever, options-related trading volumes surpassed the daily trading volume of their underlying stocks.
Generally, options aren’t something long-term investors need to think much about, but given that these instruments have been in the news and with sites like Robinhood in the U.S. and Wealthsimple Trade and Questrade in Canada making options trading easier than ever before, now’s a good time to put together a primer—in the form of a conversation with myself—to help you understand what all the fuss is about.
What are options?
Let me start by saying that all of this is fairly complicated and we’re only scratching the surface here. With that in mind, call options are contracts that allow an investor to buy a stock—typically 100 shares of that security—at a previously negotiated rate and by a certain date, while put options allow you to sell a security at a certain price and by a certain date. For this story, we’re just going to talk about call options, which are the most common kind.
OK, my interest is piqued—how do options work?
Let’s say you had your eye on MoneySense stock (I’m still waiting for the IPO) and thought the price could rise to $55 or more from the $45 it was at today. Rather than buy 100 shares for $45 at cost of $4,500 you instead purchase an option, which gives you the opportunity to buy 100 shares at $55. The option is much cheaper to purchase than the stock itself. Prices depend on the contract’s expiry date and the strike price, which is a fancy name for the price you want to buy the stock at: $55, in our case.
So if the stock hits $55, then I need to buy it at that price?
No. There are two routes that most people take. If you want to take possession of the stock, you’ll usually wait until the price climbs above the strike price to, say, $60 so that you can buy $6,000 worth of stock at $5,500. You’d then sell that stock right away and pocket $500 (less the cost of your options). You could hang onto those shares if you think the stock will climb higher, but you may want to take that profit and walk away.
You can also sell that option to someone else for a premium. If MoneySense stock hits $60, and you have an option with a strike price of $55, a lot of people will be interested in buying that option from you so that they can take possession of that security at below market value. Someone might pay $200 for the 100 options you spent $100 on. Not a bad profit.
Let me get this straight. I can put up a few bucks and then make bank by selling those shares or those options? Sign me up.
Whoa, whoa, whoa. Hold up. Call options are risky. Why? Because if the strike price doesn’t hit, that option is worthless—like, zero dollars. You will lose your $100 and never get it back. While in theory MoneySense stock could fall to nothing (and it will if they ever stop employing me, of course) there’s little likelihood that it’ll drop to zero and you can get out and keep some cash if it does start to slide.