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Understanding Options Trading

Updated: Mar 5


Options trading is an investment strategy that offers a range of possibilities for sophisticated investors. Although they are not for everyone, options can complement a traditional investment portfolio if used correctly. This article will break down the fundamentals of options trading and illustrate how they work through practical examples.



What Are Options?


An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) within a specified period or on a specific date (the expiration date). Options are derivatives, which means their value is derived from the value of an underlying asset. These assets could be stocks, bonds, commodities, currencies, indexes, or ETFs. There are two types of options: calls and puts. A call option gives the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the underlying asset.


How Do Options Work?


When you buy an option, you’re buying the possibility to buy or sell the underlying asset at the strike price before the expiration date. The price you pay for this possibility is called the premium. If the market price of the asset becomes more favorable than the strike price, you can exercise your option for a profit. If not, your potential loss is limited to the premium you paid.


Call Options


A call option allows you to buy the underlying asset at the strike price. Investors buy call options when they believe the price of the underlying asset will rise before the option expires. For example, let's say you buy a call option for Company X's stock, which is currently trading at $50. The call option has a strike price of $55 and expires in a month. If the stock price jumps to $70 within that month, you can exercise your option to buy shares at $55, then sell them on the open market for $70 each, making a profit. If the stock price stays below $55, you would likely not exercise the option, and it would expire worthless. The premium you paid for the option is your maximum loss.


Put Options


A put option allows you to sell the underlying asset at the strike price. Investors buy put options when they believe the price of the underlying asset will fall before the option expires. Consider you bought a put option for Company Y's stock, currently trading at $40, with a strike price of $35 expiring in a month. If the stock price falls to $30, you can exercise your put option to sell the stock at $35, even though it's currently worth only $30 on the open market, thus making a profit. However, if the stock price stays above $35, you wouldn't exercise the option, and it would expire worthless. Your maximum loss is the premium you paid.


Options Trading Strategies


There are numerous options trading strategies, but we will focus on few popular ones:


Covered Calls: In a covered call strategy, an investor sells a call option (also known as "writing" an option) for an underlying asset that they already own. This is typically done to generate income from the option's premium. For example, you own 100 shares of Company Z stock, which are currently trading at $20 per share. You sell a call option with a strike price of $25, expiring in two months, and receive a premium of $2 per share. If the stock price stays under $25, you keep the premium when the option expires. However, if the stock price rises above $25, the option will likely be exercised, and you will have to sell your shares at $25 each.


Protective Puts: A protective put strategy involves buying a put option for an underlying asset that you own. This strategy serves as an insurance policy, protecting the investor from drastic declines in the stock's price. Let's say you own 100 shares of Company ABC stock, currently trading at $50 per share. To protect yourself against a significant price drop, you purchase a put option with a strike price of $45, expiring in three months, for a premium of $2 per share. If the stock price stays above $45, your put option expires worthless, but your loss is limited to the premium you paid. If the stock price falls to $30, your put option allows you to sell your shares at $45, limiting your losses despite the market decline.


Long Straddle: A long straddle strategy is used when an investor predicts a big move in the stock price but is unsure about the direction. It involves buying a call and a put option with the same strike price and expiration date. For instance, imagine stock XYZ is currently trading at $50. Expecting significant price movement due to an upcoming earnings announcement, you purchase a call option and a put option, both with a strike price of $50 and expiring in one month. If the stock price moves significantly in either direction, one of your options will become profitable while the other will be almost worthless. You'll need the winning option to cover the loss from the losing one and still provide a profit. If the stock price doesn't move much, both options will end up worthless, and your loss is limited to the premium you paid for both options.


Iron Condor: An iron condor strategy is a combination of two vertical spreads (one call spread and one put spread) used when an investor expects low volatility. It's constructed by selling a call and a put (the "inner" options) at different strike prices but with the same expiration date and then buying a call and a put (the "outer" options) again with the same expiration date to limit the risk. Let's assume stock XYZ is trading at $50. You might sell a call option with a strike price of $55 and buy a call option with a strike price of $60. At the same time, you sell a put option with a strike price of $45 and buy a put option with a strike price of $40. All options have the same expiration date. This strategy creates a profit range between $45 and $55. If the stock price ends within this range at expiration, the inner options expire worthless, and you keep the premium from selling those options. The potential loss is limited by the outer options you bought.


Bull Call Spread: A bull call spread strategy is used when the investor believes the price of the underlying asset will moderately rise. It's executed by buying a call option while selling another call option with a higher strike price, both with the same expiration date. For example, if stock XYZ is trading at $50, and you expect it to rise but not beyond $60, you could buy a call option with a strike price of $52 and sell a call option with a strike price of $60. If the stock price rises to $60 or above, both options are exercised, and the profit is the difference between the strike prices minus the net premium paid. If the price stays below $52, both options expire worthless, and your loss is the net premium paid.


Bear Put Spread: A bear put spread strategy is used when the investor believes the price of the underlying asset will moderately fall. It's executed by buying a put option and selling another put option with a lower strike price, both with the same expiration date. Suppose stock XYZ is trading at $50, and you anticipate a moderate price drop. You might buy a put option with a strike price of $48 and sell a put option with a strike price of $40. If the stock price drops to $40 or lower, both options are exercised, and the profit is the difference between the strike prices minus the net premium paid. If the price stays above $48, both options expire worthless, and your loss is the net premium paid.


Remember, these strategies are quite advanced and should be attempted only by investors who have a solid understanding of how options work.


Advantages of Options Trading


  • Flexibility: Options offer the flexibility to profit in any market direction – bullish, bearish, or sideways.

  • Leverage: Since options derive their value from an underlying asset, you can control a significant amount of that asset without owning it outright, offering the potential for significant profit from a relatively small investment.

  • Risk Management: Options allow investors to hedge their portfolios against unfavorable price movements, as in the protective puts strategy.


Risks of Options Trading


  • Complexity: Options are complex instruments that require a deep understanding of financial markets. It can be easy for novice investors to get confused and make costly mistakes.

  • Potential for High Losses: While buying options limits risk to the premium paid, selling options can result in substantial losses if the market moves unfavorably.

  • Time Decay: All options have an expiration date. As the expiration date nears, an option's value can decay if it's out of the money, leading to potential losses.


Options trading offers a sophisticated set of tools for potential profit and risk management, but it's not without risks. Understanding the intricacies of different strategies and managing risks effectively are critical for success in options trading. Before diving into options trading, consider your investment goals, risk tolerance, and trading knowledge. If you decide to proceed, it's advisable to start slowly, gain experience, and perhaps seek the guidance of financial advisors or use educational resources to help navigate this complex landscape. Remember, knowledge is your most valuable asset when it comes to investing.


 

The largest options market in the world, the Chicago Board Options Exchange (CBOE), wasn't established until 1973. Despite options trading having roots in ancient times, standardized or exchange-traded options are a relatively recent invention. Before this, options contracts were primarily negotiated and traded in over-the-counter (OTC) markets, which lacked the transparency and regulatory oversight present in today's exchange-based trading. The creation of the CBOE and the standardization of options contracts revolutionized options trading, making it more accessible, transparent, and popular among investors.

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