What you need to know about options

Photo by Fernando Arcos from Pexels

Remember when shares of GameStop, the bricks-and-mortar videogame store, rose by more than 700% in a week thanks to a group of Reddtiors who all bought the company at the same time? With its stock now at $50 and falling—it’s down 85% since January 27 (though it’s still up 195% year-to-date)—this story will soon be a distant memory, left to investing lore.

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.

But it’s just $100.

OK, moneybags. Sure, if you want to test the market and don’t mind losing $100 then that’s fine. But most people aren’t doing this just once or for that amount. Depending on when you buy and for what strike price, an option can cost a lot more than $1. Yes, it’s still below the stock price, but you could be on the hook for a few thousand bucks. As well, if you want to make real money, you’ll want to buy options for more than 100 shares, and there’s a good chance you’ll be doing this over and over again. See how all that can add up to potentially big losses?

Hmm…. Is there any reason that I, a diligent MoneySense reader who is holding a diversified basket of ETFs for the long-term, should buy options?

The short answer is no. There’s really no reason you should consider call options (or put options), unless you want to have a little fun, which we don’t frown upon—but just make sure you have that money to lose.

There is a situation where you might want to consider writing options—that is, providing options, on the stock you own, to someone else. If you’re a retiree, say, and want to make some extra money on the blue-chip stock you’re holding, you could give someone else the option to buy your stock. You’d pocket the cost of the option and they may or may not want to take possession of those shares in the future. This is possible to do on sites like Questrade, and some advisors are doing this kind of thing for clients to help them generate some extra yield, but proceed with caution.

What do options have to do with GameStop?

Because it’s a lot cheaper to buy options than the stock itself, people who don’t have a lot of money—like, say, 20- and 30-somethings on Reddit—can get in on the action for a few bucks and win big if the price rises. This is partly what happened with GameStop. It’s complicated, but when people buy options, a market maker—someone who ensures that there’s liquidity in the market—has to buy the underlying stock so that if the option holder decides to take possession of the stock, the securities will be there. With so many people buying options (and also the stock itself) the share price climbed. (There’s also the short squeeze, which contributed to the rising price, but let’s save that for another day.)

What’s changing here is that options are becoming much easier to buy, thanks to technology. While more option trading shouldn’t move markets in a significant way itself, unless we see another stock go viral, this whole GameStop drama has put the spotlight on these kinds of contracts and the risks associated with them. Retail investors must remember to not get caught up in the hype and to proceed with caution around financial instruments that may sound cool right now, but could get you in trouble. A number of sites allow you to test these kinds of markets out virtually, with play money—so, if you do want to give options trading a try, start there.