The 10 Key Principles to Option Investing

"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.

Traditionally, a call option is depicted graphically on a "payoff diagram," as shown to the right for our example. In a payoff diagram, the stock price at expiration is shown on the x axis and the profit is shown on the y axis.

The payoff diagram shows a payoff starting at $50, and rising toward the right.

Obviously, someone is not going to agree to give you the upside from $50 over the next year without some compensation in return, which is why the payoff line starts below zero. Someone is going to require you to pay him for that right to the upside, and this distance below zero is the price you have to pay for the option. The real question--and the key to options investing--is deciding what the upside is worth, and comparing that with the price the seller is trying to charge you. That's what separates the investors from the gamblers when it comes to options investing. We'll get into that discussion later, but simply keep in mind that there's some price to be paid for the "right to the upside."

Puts: The Downside
Just as I think about calls as "the upside" on a stock, I think of puts as "the downside" on a stock.

For example, let's say you're considering selling stock in XYZ, which is trading at $50, because you think the company is overvalued and that the stock price will fall over the next year. If you sell the stock short at $50 (selling a stock short is selling the shares in the hope that you can buy them back later at a lower price, making a profit), you take a risk that the stock will rise above $50, in which case you will lose money.

But let's say I agree to pay you the entire stock price decline from $50 over the next year. If the stock price falls to $40, I will pay you $10. If the stock price rises above $50, I won't pay you anything, and you don't owe me anything. In this example, I've given you the downside on the shares of XYZ below $50, without forcing you to assume any of the risk to the upside.**

Again, let me repeat that: I've given you the downside on XYZ below $50 for the next year. What I've given you is also known as a $50 strike one-year put option.

Principle 2: Value Options Using Company Fundamentals
Now that we've established that a call is the upside from a strike price, and a put is the downside from a strike price, I can tackle the question of how to determine what the upside and the downside are worth. Remember, this is the key to investing--as opposed to gambling--with options.

There are many different ways to estimate the value of an option, but I like to boil them down to two distinct methods: the fundamental view of options and the statistical view of options. Despite the fact that the options market revolves almost entirely around a statistical view of the world, we'll begin by describing the world from a fundamental perspective, both because it is easier to understand and because it closely aligns with the way I use Morningstar research to uncover investment opportunities.

Options Pricing in Plain English
If the stock of a company is currently trading at $50, how much would you pay someone for the upside above $50 for the next year?

Let's start with a simple example, A Tale of Two Tickers.

Gizmo Inc. is just about to launch a new fashion line, "New Gizmo," and its stock price is trading at $50. All fashion retailers are exposed to the latest fads, and Gizmo is no different: Its new fashion line could be wildly profitable, or it could be a complete dud.

You can think about the present stock price of $50 as an average of Gizmo's potential stock prices in the future, weighed by the probability of each price. To the upside there might be a 10% chance that Gizmo's new line will be a huge hit and will support revenues and profits enough to drive the stock price to around $500. To the downside, there might be a 90% chance that Gizmo flops and the stock is worth zero. A 10% probability of a $500 stock price is worth 10% * $500 = $50; a 90% chance of $0 is worth 90% * $0 = $0. Adding the two together, $50 + $0 = $50, the present market price.

Another company, SugarWater Inc., is also trading at $50. SugarWater Inc. is in the business of selling SugarWater: It has been selling it for 100 years and sells pretty much the same dollar amount of SugarWater every year, plus or minus a few percent. This year the company has a 50/50 chance of 0% growth or 3% growth, and the stock would either be worth $45 or $55, respectively. Again, we are just taking the estimates of the possible outcomes and their probabilities and combining them, we get (50% * $55) + (50% * $45) = $50.

Let's compare a call option on Gizmo with a call on SugarWater. Both stocks are trading at $50, but we're looking to put a value on "the upside" from $50 over the next year. For these two companies, we should be willing to pay very different amounts for the upside.

If Gizmo's new fashion line is a big hit, it will have a $500 stock price by the end of the year, and the upside in that case is $500 minus the present market value of $50, or $450. If our probability estimate of a 10% chance of that upside scenario turns out to be correct, then using the same probability weighting I spelled out earlier, the upside should be worth $45 (10% times $450).

What about SugarWater? If it comes through with 3% growth, the stock has an upside of $5 ($55 minus $50). If our 50% probability estimate of the upside scenario turns out to be correct, then the option should be worth $2.50 (50% * $5).

As we can see, the two stocks have the same price, but the upside--or call options--are worth very different amounts. The options on SugarWater are less valuable because the value of SugarWater's stock is relatively certain, while the value of Gizmo's stock is very uncertain.

This is the key intuition behind the valuation of an option! The higher the uncertainty about the value of a stock, the more valuable the option. All other things held equal, a higher option price implies that there is a much wider distribution of possible outcomes for a certain stock.

Click here to download the rest of Morningstar's free Option Investing Guide, including Phil's remaining key principles to option investing.

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* The mechanics of the actual transaction to capture the upside are slightly more complex than I've laid out here because technically, the option seller agrees to give the option buyer the shares for $50, or allows the buyer to "call" the shares away at $50, hence the name "call" option. If the stock price is at $60, by calling the shares away at $50 and reselling them, the buyer can capture the upside I've been discussing. For practical purposes, however, the call owner can sell the stock immediately after calling it, and it is so much simpler to think of the definition as the "upside."

** Again, the mechanics of the transaction are slightly more complex. Technically, the option seller agrees to let you, the put buyer sell the shares for $50, or "put" the shares to the option seller for $50, hence the name "put" option. For practical purposes, however, the put owner can buy the stock and immediately put it to the put seller, which produces the profit from the drop in the stock price. It is much easier to think of a put as "the downside."