Options feed into the concept of choices. Everyone loves to have a choice when making decisions, and options provide you with the choices to make buying/selling decisions in the financial markets.
Like most things, options trading is a double-edged sword with benefits and risks. Before considering the risks and benefits of options, it is essential to understand them fully. This article discusses the vital bits about options, how to trade them, and their advantages and disadvantages.
What Is Options Trading?
Options are a set of financial derivative contracts that give the investor the right, but not the obligation, to buy or sell an underlying asset at a specific price within a timeframe. They’re pretty similar to futures, but the major difference is that options give you the right to complete a trade, but it doesn’t force you to, while futures “force” you to meet the trade. Similarly, options and futures are traded on approved exchanges with brokerage investment accounts.
A significant difference between futures and options is the use of different terms. There are different words an options trader must get familiar with in options. Some of them are:
- Call option— It means buying an asset at the set price on or before the expiry date.
- Put option— This means selling an asset on or before a particular date.
- Strike— Strike means the price at which a call or put option is exercised.
- Premium— the premium is the price paid to buy an option.
Options offer a good amount of leverage and protection that can improve an investor’s portfolio. They are flexible enough to be tweaked to meet an investor’s goal. Just like futures, options are also great for hedging and speculation purposes. In fact, some say that options were created for hedging purposes.
Using options as a hedge reduces risks at an average cost. It works like an insurance policy for ensuring investments against downward market turns. Using put options, you can limit downside risks and profit from all the upside movement. Options can also be used as a hedging strategy in short selling. Short sellers apply call options during a short squeeze, which helps them limit losses.
Options are helpful in speculation too. If a speculator predicts an upward price movement, they could buy a call option on the asset. When using the call option, the speculator is given leverage as they only have to pay a few dollars or cents instead of the total price of the asset involved. That way, even if their prediction was wrong, they’re secure because their loss is curtailed to a minimum.
The Essentials Of Options Trading
Options contracts are typically regarded as wasting assets because their worth is linked to the time between contract launch and expiration. Simply put, the closer an option is to its expiry date, the lesser its worth. The reason for this is simple; price movements are predicted based on future events, so for an options contract to have worth, it has to be far away from its expiration time so that price movements can be calculated rightly and timely locked in. For example, a five-month options contract is worth more than one of two months.
Similarly, a twelve-month options contract is worth more than a five-month contract. This is a result of time decay— the rate of decline of an asset’s value due to time passing. Options value also increases due to volatility because it increases the chance of an event happening. The more volatile an asset is, the higher the options price. The fluctuation in an option’s premium depends on its intrinsic and extrinsic (time) value. A premium is made up of both values.
An intrinsic value is the direct value of an options contract which could be the amount above the asset’s strike price. The extrinsic (time) value is the added fee the investor pays for an option above the intrinsic value. In most cases, options trade above their intrinsic value because the odds of an event happening are never zero, even though it might be unlikely.
How To Trade Options?
While different options trading tactics range from simple to highly complicated, the basic concept is to use options to bet on high prices, using call options. Conversely, if you use options to bet on downward price movements, you use put options.
A strong reason options are highly sought after is because they are flexible. In options, you are not obligated to fulfill your contract. You can walk away at any time and just stand to lose the premium fee paid for the contract. Subsequently, trading options are a cost-effective way of speculating on a wide range of asset classes.
Once you’re approved for margin and options with your broker, you can trade options seamlessly. With options, you can speculate on
- Whether an asset’s price will increase or decrease.
- How much the asset will lose or gain.
- The time predicted for the price movements to happen.
After analyzing the asset’s price movements using fundamental and technical analysis, you can make profits by trading the asset’s options through the call or put option, depending on if it’s an upward or downward movement. With a call option, you make a profit when the asset’s price is above the break-even price, and you close your position— selling the call option— and make gains through the difference between the initial and current premium. You can execute the option by buying the asset at the agreed strike price.
With a put option, you earn profits after closing your position when the price falls below the break-even price. You can also execute the option by selling the asset at the agreed strike price. If the price moves more towards an opposite angle, simply let the contract expire, and the only loss you’ll bear is the premium plus trading fees. Note that those who buy options are called holders, and those who sell options are called writers.
The difference between them is that the call-and-put holders are not obligated to sell. They have the “option” to do it or not, but it’s not an obligation. However, the call-and-put writers (sellers) are obligated to sell. Sometimes, it may be mandatory for a seller to fulfill their promise of buying or selling. It also means that writers are exposed to higher risks, which could mean losing more than their premium. Overall, options trading is pretty straightforward, but it becomes more complicated when two or more techniques are paired together. Experts mostly use this method.
Advantages Of Trading Options
Options trading has many upsides, some of which have already been discussed in this article. However, there are still more advantages of trading options, which you should know.
Options help to hedge your assets against maximum risks. They act like insurance for your capital in case the underlying asset’s price goes contrary to expectations.
Losses Are Limited to the Premium
The contract premium is your initial investment when you buy call or put options. Since you’re under no obligation to buy or sell the underlying asset, if your prediction turns out to be wrong, you only lose your initial contract premium. No further losses are incurred.
Variety of Trading Strategies
With options trading, you have many options (pun unintended). For example, you can combine trades in both directions to maximize profit and minimize losses, use calls and puts of different expiry dates and strike prices, and formulate strategies to take advantage of volatility or time decay.
The kind of leverage that options offer you is the kind that allows you to pay a fraction of the underlying asset’s value to gain the same exposure as someone holding equivalent futures or spot positions. It means you spend less money to hold the same value as the other guy who spends more because he’s not trading with options. This leverage allows you to gain profits from a relatively minor capital investment.
Disadvantages of Trading Options
As advantageous as options are, they also have disadvantages.
While there are general trading terms, options have unique lingo that the beginner may initially struggle to understand. Terms like put, call, at the money, etc., and Greek words like rho, vega, theta, and gamma can further confuse a beginner and make things seem more complicated. You can remedy this by learning them and getting the hang of them as time passes.
Options are time-bound; thus, they must be exercised on or before a set time limit, after which they become worthless. So, for you to make a profit, you must not only accurately predict the direction of the market but also the precise timing. Doing this could result that you may have accurately predicted that the price would go in a particular direction (maybe up), but if it doesn’t happen within the set time limit of your options trade, you may lose money.
Time decay is a situation whereby the value of your option premium gradually decreases by some percentage each day. It means that the closer the expiration date, the more decay. It’s not uncommon for options to expire worthlessly. Therefore it’s usually best (and more common) to use options on a short-term basis. It’s worth noting that this situation happens regardless of the underlying asset’s price movement.
Not all assets have options, thus being limited to specific assets.
Options are financial derivative contracts that offer the choice to buy or sell an underlying asset at a fixed price before a deadline. While they’re advantageous by being flexible and low-risk, they also have their disadvantage as their worth decreases as time passes. Options might be a worthy venture, but before venturing into it, it is advised to research to analyze risks and other factors.
Diana is the CTO of Vestinda.
She’s an engineer with extensive experience in the payments space, passionate about mathematics and artificial intelligence.