A a little over 20 years I was studying various investment products for required exams to start my career as a financial advisor when I first heard of stock options. Several people ahead of me failed the exam because of option trading strategies section.
The two words that come together to create yet another instrument for investing in securities. Options Trading.
Trading, as is perhaps well understand, is the act of buying and selling with the objective of making a profit. In the context of financial securities, it has the same meaning, with specific reference to trading in financial instruments with the objective of making a profit.
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An Option may, however, need to be better understood. If you get confused, don’t worry. I have included above an option trading cheat sheet to help you get back on track.
- 1 What is an Option for Stocks?
- 2 Types of Options
- 3 How Do I Start Trading Options
- 4 Trading Strategies
- 5 Why Should Investors Use Option Trading Strategies?
What is an Option for Stocks?
Before we get started, you may be asking what is an option. The short answer is that an Option, in the pure English sense of the term, is a choice. In the context of securities, it has a similar meaning. It is a contract which, once entered into, affords a choice to the buyer (of the contract), the ‘option’ to buy or sell the security underlying the contract, at the price agreed in the contract, till the time the contract expires.
Key features of Options:
- An Option does not represent a share of an asset, like stocks representing part ownership in a corporation. It is only the right, or ‘option,’ to do so at a later date which may or may not be exercised. It allows, but DOES NOT REQUIRE, buying or selling.
- As in any type pf contract, an Options contract also needs a buyer and seller, with a difference in their expectation of the future, based on which an opportunity arises for them to make a profit from it.
- An Option does not have an independent existence. It needs an underlying security to come into existence. Its pricing is also based on the value of the underlying security. Hence it is also called a ‘derivative’ instrument and is a part of the larger ‘derivatives’ universe of financial instruments.
- An Options contract can be originated for a fee charged by the seller, usually called the premium.
- The price at which the contract buyer has purchased the ‘option’ to do the transaction within the defined period, can be, and is usually, different from the current value of the security, and is known as the Strike Price.
Types of Options
There are two types of Option contracts:
What is A Call Option?
In this contract the investor gets the right to buy an underlying security, say 100 shares of ABC Ltd., at a pre-determined price, the Strike Price, till the expiry day of the contract, say 3 months.
An investor typically enters into a Call Option when he expects the price to rise beyond the Strike Price at which the option is available for that period.
Let us take an example.
Shares of ABC Ltd. are currently priced at $100.
Mr. X, an investor, is expecting an upward movement over the next three months in the price of ABC to at least $140. However, in his view, the upward movement is based on events which are uncertain. If he waits for the events to happen, the market will factor that into the price and his opportunity will vanish. And, if he buys the shares at $100 today, he runs the risk of a potential loss if events as expected do not materialise and the stock price falls.
PQR Securities, a brokerage firm, is offering 3-month options for a strike price of $110 at a fee (premium) of $5. This means they are willing to sell shares of ABC for $110 for the next 3 months to investors willing to pay them an upfront fee of $5.
In this scenario, Mr. X could choose the Call Option contract.
He can choose to buy an Options contract for a premium of $5 from PQR. If events happen as he has envisaged and the price of ABC goes up, he can exercise his right to buy the shares at $110 and sell them at $140 and realise a profit.
If the shares do not move up as expected, or go down, he can just pay the $5 premium to PQR and walk off. He does not need to buy the shares.
As can be understood, the lower the strike price agreed for a Call Option, the greater the intrinsic value of the contract. In other words, the greater the potential profit.
What is a Put Option?
This is the opposite of a Call Option and gives the investor the right to sell at a pre-determined price.
An investor would typically buy a Put Option when he expects a drop in the prices of the underlying security.
As can also be understood, the greater the strike price agreed for a Put Option, the greater the intrinsic value of the contract. In other words, the greater the potential profit.
Long and Short Options
Whether a Call or a Put Option, in other words, whether with an expectation of price going up or price going down, an investor buys an Options contract. In trading parlance, this is known as a ‘long.’ In other words, you are buying a long option.
When you sell an option, in trading parlance, you ‘short’ it.
In both Put and Call Options, there will be an element of erosion of premium as the term remaining reduces. This is also known as ‘time decay’ of price. The greater the time left to expiry, the greater the premium.
How Do I Start Trading Options
In simple terms, options trading is trading in options, or buying and selling of options, and is only done through a brokerage.
The strike price of an Option is based on the current price of the underlying security. For a Call Option, any strike price that is above the current price, is known as ‘out of money.’ If the strike price is lower than the current market price, it is referred to as ‘in the money.’
For a Put Option, it is exactly the opposite. A strike price that is above the current price, is known as ‘in the money’ while a strike price lower than the current market price is referred to as ‘out of money.’
In our example above, the strike price of $110 against a current price of $100, will be known as ‘out of money’ if the investor is buying a Call Option and ‘in the money’ if it is a Put Option he is investing in.
If the strike price is the same as the current price, it is known as ‘at the money.’
Premium of an option is determined primarily by the value of the underlying security and time left to maturity or expiry of the contract. Volatility of the underlying security also has a bearing on the premium.
Volatility – As can perhaps be intuitively divined, higher volatility means higher risk, and vice versa. As a result, Options on stocks with high volatility will be available for higher premia, as the seller will charge a higher risk premium. As with everything else, historical volatility is used as an indicator of volatility of a stock. An effort can also be made to estimate implied volatility, in other words expected future volatility.
Time Value – This is also known as ‘extrinsic value,’ the value over and above the value arising from the underlying security. Premium on an Option will be higher the further away it is from its expiry. This is because it has more time available to make a profit. By the same logic, the closer it is to expiry, lesser the time value and lower the premium.
From a beginner’s perspective, here are some that have been tested over time:
What Are Straddles and Strangles?
Straddles is adopted in a situation when significant volatility is expected, but its direction is difficult to predict. For example, when quarterly results are about to be announced, a stock could react either way, depending on the announcement.
This strategy essentially involves buying a Call and a Put option at the same time, same strike price and same period. As long as there is a significant movement that covers the total premium that is paid, the investor will make money.
The Strangles strategy requires buying an ‘out of money’ call and ‘out of money’ put contract at the same time for the same asset and same expiry. This is also used where volatility expected is high. A Strangle is considered to be a relatively safe strategy since the premia are for ‘out of money’ contracts are typically less expensive.
What Are Covered Call Option Strategies?
This is executed by buying 100 shares of a regular stock and selling one call option per 100 shares of that stock.
This helps reduce risk of current investments and provides a profit-making opportunity from the Option. It is considered good for investors who are neutral or slightly bullish, and have long stock investments.
Using this strategy, a sharp fall in stocks could lead to losses, but, if prices stay constant or increase, this will make you money.
What Are Selling Iron Condors Option Strategies?
This strategy can be fine-tuned to suit the risk appetite of an investor. The direction of movement of the underling security becomes immaterial using this strategy.
Execution of the strategy is by selling a put and buying another put at a lower strike price creating a put spread. This is combined with buying a call and selling a call at a higher strike price, thus creating a call spread. As long as the price of the underlying security stays between the two puts or the two calls, you make a profit.
Like in any investment strategy, there is a downside too. This strategy will result in losses if the security goes sharply above or sharply below the spreads.
Why Should Investors Use Option Trading Strategies?
What Are The Advantages Of Option Trading?
Hedging – Allows investors to reduce risk at a reasonable cost, especially where downside risk of value erosion is significant. In such a case, an Option could be seen like an insurance contract.
Limiting outlay – Trading in stock requires significant outlay. In our example, if the investor has a pot of $1000, he can buy 10 shares of ABC for a potential gain of $40 per share, or a total of $400. With a Call Option, for a fee of $5 per share, he could potentially stand to gain from 200 shares ($1000 / 5), and stand to gain $30 from 200 shares, or a total of $6000.
In its trading tips, Nasdaq offers arguments like resilience to price volatility, increasing income, better deals on a variety of equities and, perhaps most importantly, capitalizing on movements without having to invest in it directly, in support of Options.
What Are The Limitations Of Option Trading?
As in any investment or deal, market volatility will always be a source of risk. One needs to tread with caution, analyse available information, and act. Greed can destroy wealth in any business.
How To Avoid Common Option Trading Mistakes
Many traders think that the Option has to be held till expiry date. That is not the case. The contract might yield better value if offloaded before expiry.
As with stocks and other securities, selling of exiting is normally the more difficult choice to make. Same is the case with Options.
Cheaper is not necessarily better. The focus has to be on value creation.