A Beginner’s Guide to Options Trading
An option is a conditional derivative contract where the buyer can buy or sell whichever security they hold at a predetermined price. The sellers charge the option buyers a premium for this right. If the market price is unfavorable, the option holder can choose to let the option expire. This way, the losses incurred do not exceed the premium. On the other hand, the sellers also referred to as option writers, take on higher risk than the buyers, hence the reason for charging premiums. Click Here To Go Straight To Our Online Tutorial
There are two types of options; put and call options. In a call option, the investor has the right to purchase an underlying asset at a set price in the future (strike price/exercise price). In a put option, the investor has the right to sell the asset in the future at the set price. Essentially, when trading in options, you buy the right, but not an obligation to complete the trade.
Why Use Options
There are several reasons why investing in options would be suitable, including hedging, speculation or the allure of a synthetic position. There are other reasons for investing in options, but we will discuss the major ones only.
This is investing in the possible future price of an asset. A speculative investor, based on a gut feeling or other reason, might have faith that the price of a certain stock will appreciate in the future. With this in mind, they plan to sell the stock at a premium, making profits in the process. This is how call options work. Instead of purchasing the stock upfront, the option is more attractive to an investor because it allows them to leverage.
It might cost just a few dollars for an out of the money call option, compared to a stock worth $100. This is one of the reasons why options are considerably risky investment tools. By investing in an option, you must be sure about the position of the stock, and the possible movement. You must also be careful about the timing and magnitude of the investment. Those who make good returns from options trading usually predict whether the stock will move up or down, how much the price will move, and the duration within which all this will take place.
Options are primarily investment instruments for hedging, not for speculative purposes. Hedging is a means of reducing your investment risks but at an affordable cost. Because of this reason, buying options is like taking an insurance cover.
The same way you pay insurance premiums to protect your car or your house, is the same way options are used to protect your investments against the risk of a downturn. According to critics, you should not invest in the first place, especially if you are so unsure about it that the need to hedge arises.
Hedging strategies have always proven to be effective, especially for institutions with sizeable disposable income. Even individual investors can strike major benefits from trading in options. Take a technology stock, for example. You might be interested in investing in one, but also want to limit the risks. If you purchase an option, it is possible to restrict the losses, while at the same time enjoying the cost-effective benefits. For investors who like to trade in options, especially short sellers, a call option can work in the same way, to limit your losses in the event of a short squeeze, or if you made an incorrect short bet.
Taking two or more positions in an option is called spreading. The effect is that you combine the benefits of speculation and hedging. More often, a spread will restrict your potential benefits. However, this is an effective strategy considering the low cost of implementation.
Spreads generally involve buying one option after selling another. In this market, you can experience the true volatile nature of options, especially since you can come up with a spread to help you maximize on whichever market outcome, even for markets that stay inactive. We will address this later on.
What Are Synthetics
Synthetics are a unique type of spread. They are used to create a position with the same behavior as a different position, without necessarily having to control that particular asset. A good example is purchasing a call at the money, and at the same time, selling a put with the same strike price and expiry date. This will have created a synthetic long position in the asset.
Wouldn’t it be better to purchase the underlying asset instead? Well, that might be true, but most people consider synthetic options for different reasons, including regulatory or legal reasons barring them from buying underlying assets, which do not stop them from investing in a synthetic position. Another reason might be because the underlying asset might be an index, making it difficult to build from the individual components.
For beginners, the following are simple basic strategies for investing in options:
This is a good strategy for an investor who:
Is bullish on a specific stock, index, ETF or would simply want to limit their risk
Wants to exploit rising prices by leveraging
Options are basically leveraged instruments in the sense that the investor can risk a smaller amount against the hope of a bigger profit than what they would have otherwise needed to spend if buying the underlying asset. Standard options contracts usually involve 100 shares of the underlying asset.
Assuming the investor wants to buy Apple shares (AAPL) worth $5,000, with the shares trading at $165 per share, they can easily buy 30 shares at $4,950. In the event of a 10% increase in the stock price to $181.50 within the next one month, this investor will see their portfolio value rise to $5,445, assuming we do not factor in the fees like commissions and other transaction fees. The investor, therefore, has a net dollar return of 10% on the invested capital, or $495.
Let’s picture a situation where the strike price of $165 is available on a call option that expires in one month. The call option costs $550 per contract or $5.50 per share. Based on the investment budget the investor has, they can easily invest in 9 options for $4,950. Since the option contract is worth 100 shares, the investor can contract on 900 shares.
Should the stock price appreciate by 10% to $181.50 upon expiry, the option will also expire in the money and will be worth ($181.50 – $165) $16.50, or $14,850 on 900 shares. The net dollar return on this investment will be $9,990, which is a 200% return on the invested capital, much larger than investing directly into the underlying asset.
Risk/Reward: The potential loss from a long call for the trader has been restricted to the amount they pay in premiums. The profits, on the other hand, are unlimited. This is because the payoff increases together with the price of the underlying asset, until the point of expiry. Theoretically, there is no maximum limit.
Long puts are a preferred investment tool for investors who:
- Are bearish on a specific index, ETF or stock, but would also like to risk less than short selling
- Would like to exploit falling prices by leveraging
Put options are a direct inverse of call options. Put options appreciate in value against a decline in the value of the underlying asset. Short selling would see a trader profit from the decline in prices, though in a short position, the risk is unlimited. This is because, in theory, the highest the price can rise has no limit. With put options, therefore, if the underlying asset appreciates beyond the strike price of the option, the option becomes worthless and expires.
Risk/Reward: Losses are restricted to the value of the premiums paid when buying the options. There is a maximum cap to the possible profits earned because it’s impossible for the value of the underlying asset to drop below zero. Similar to long call options, put options also leverage the investor’s returns.
A covered call is ideal for investors who:
- Do not expect any change or increase in the value of the underlying asset
- Would exchange downside protection for limited upside potential
Covered calls involve investing in 100 shares of the underlying asset, then putting a call option for sale against the same shares. When the investor sells the call, they collect the premiums on the option, reducing the cost in the process, and providing protection from the downside.
The seller, on the other hand, agrees to sell the shares of the asset at the strike price, capping the upside potential for the investor.
Let’s take the example of an investor who buys 1000 BP shares trading at $44 each, and at the same time, writes 10 call options at a $46 strike price that expires in a month at $0.25 per share (for 10 contracts, $250).
The $0.25 premium will reduce the cost on their shares to $43.75. Therefore, any decline in the price of the underlying asset at this point is offset by the premium they receive from the option, hence limited protection from a downside position.
Before the option expires, if the share price goes beyond $46, the investor can exercise their short call. In this case, the trader delivers the stock at the strike price. The investor then makes a profit of $2.25 for each share ($strike price $46 – cost basis $43.75)
However, according to this example, the investor does not believe the price will move beyond $46 or go lower than $44 within the next month. The trader gets to keep the premium and is also free to sell the calls against any shares if they choose to, as long as the shares are not called away before the options have expired, or if the price does not increase beyond $46.
Risk/Reward: In case the share price increases beyond the strike price before the option expires, the trader must deliver the shares of the underlying asset at the strike price if the investor decides to exercise the short call option. This happens even if it is lower than the market price. For this risk, a covered call is a strategy that offers limited protection in the event of a downside through premiums when the call option is sold.
A protective put is an investment tool used by traders who fall in any of the following categories:
Need downside protection over an underlying asset they own
Protective puts are long puts. Just like the strategy we have looked at above, the concept here is to protect the investor against a downside, while at the same time making a move to profit from the downside. If the investor owns some shares that they are bullish about in the long run but would wish to shield themselves against a short-term decline in value, a protective put would be an ideal way to go about this.
An option becomes worthless and expires in case the price of the underlying asset rises at maturity, above the strike price. The investor will forego the premium, but will still benefit from a better underlying price. If the price of the underlying asset falls, the investor’s portfolio will lose value. However, the loss will be mitigated by profits from the put position. This is why this is a position that most investors consider a wise insurance move.
The investor has the option of setting a strike price lower than the current price to reduce the premium payments, over the risk of lower downside protection. This works like deductible insurance. Let’s run this through an illustration. The investor purchases 1,000 Amazon shares at $44 and wants to lock them in for two months, to protect their portfolio investment from adverse price movements within that period.
Understanding The Risk/Reward
In case the price of the asset increases or stays the same, the possible loss will be mitigated and limited to the premium paid, which is like paying for insurance. On the other hand, however, in case the price of the underlying asset falls, there will be a loss in capital. This loss in capital is offset against any increase in the price of the option and will also be limited to the difference between the strike price plus the premium paid, and the initial price of the stock at the time of purchase.
For investors who like to trade in underlying assets, options provide good investment vehicles. There are different strategies that can be used to invest in a variety of underlying assets, options, and derivatives. Basically, for beginners, you would consider buying puts, calls, protective puts or selling covered calls.
There are benefits of trading in options instead of underlying assets, including protection against the downside and the ability to leverage your returns. However, there are also challenges, including paying for premiums upfront, which might put off some investors.