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Investing Specialists

The 10 Key Principles to Option Investing

Understand upside and downside, and value options using the fundamentals.

Philip Guziec, CFA

Dec 1, 2008

Principle 1: Understand Upside and Downside
The textbook definition of an option is:

"The right, but not the obligation, to buy or sell a specified asset at a predetermined price over a predetermined time."

While the definition is precisely correct, it makes my eyes roll when I read it. Let's see if we can develop a better working definition.

Calls: The Upside
I think about calls as "the upside" on a stock.

Let's walk through a comparison between a stock investment and an options investment to understand what I mean by "the upside."

Let's say you're considering buying stock in XYZ, which is trading at $50, and you think the company is undervalued. You believe that the valuation will return to normal over the next year. If you buy the stock for $50, you put $50 at risk and you hope that the share price rises over the next year, earning you a profit on your $50. Of course, if the stock price declines over the next year, you lose some of your $50.

Alternatively, let's say someone agrees to pay you all of the return above $50 over the next year. If the stock price rises to $60, he will pay you $10. If the stock price declines below 50, he won't pay you anything, and you don't owe him anything. In this example, he's giving you the upside on the shares of XYZ. Anything above $50 is yours to keep.*

Let me repeat that: He's giving you the upside on XYZ above $50 for the next year. This is also known as a 50 strike one-year call option.

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