You, like many others before you, are wondering what are options and what is options trading. Once you have started on your trading journey, you may have ventured into one of the helpful trading forums or chatrooms, and come across people talking about options trading.
It is usually this that makes one wonder, what even are ‘options’ and how do I begin to start trading options seeing as everyone else is talking about it.
Firstly, we need to take a step back as with any financial instrument and do a bit of fact finding to see whether this type of trading is in fact for you. Options trading can be very fruitful if successful. It can also amplify losses significantly beyond those planned if you are not careful.
Let’s run through the basics together below alongside some potential advantages and disadvantages of trading options.
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What is Options Trading?
Why do people begin trading options?
Options trading for speculative purposes
Options trading for hedging
Options trading for flexibility
Key Terms in Options Trading
Advantages of Options Trading
Disadvantages of Options Trading
What is Options Trading?
Options Trading is a form of derivative trading. It allows potential traders to profit (or loss) from the underlying financial instrument without actually owning the aforementioned.
The reason options are called options, is because you have the right to buy or sell the asset at the agreed price, or to withdraw from the agreement at any stage. You therefore have the ‘option’ to buy but not the obligation.
This option cannot of course be taken without cost, as otherwise you would have the right to open as many options as you wanted on both sides of the trade and only execute the profitable ones!
Options trading is made possible by a binding contract that both parties (buyer and seller) agree to buy, or sell said instrument at a predetermined price, over a set time period but without you be obligated. It is the agreed price that is fixed therefore and not the trade itself.
Options Trading Premium
So, why does a broker allow you to agree to an options trade but not execute one at the same time? There is what is called a ‘premium’ paid on the contract itself.
The options premium works much like a deposit in many other transactions where you would like the right to buy, but still retain the right to withdraw if you prefer. If you choose not to fulfill your end of the contract, it would be at the loss of the deposit, or premium in this case. It is here then that the broker has a reason to provide a market on the trade whether you choose to fulfil the contract or not.
Why do people trade options?
There are many reasons that people trade options but typically there are a few that cover the main reasons.
The main reasons you might want to execute options usually fall into one of three categories; hedging, speculating, and just for the flexibility afforded.
Trading Options for Speculation Purposes
Options trading allows you to speculate and leverage a future price without buying the initial asset and is popular with traders as they are seen to be less risky. If you are trading options, you are able to exercise the right to buy or sell at any point up to the agreed expiration date. In essence, you can speculate on a risky stock or asset without the downside risk being any greater than the premium paid.
If you are trading an option on a very volatile asset that has the potential to swing 50% to the upside (or downside) on a certain event, trading options in that asset would give you the right to profit from that swing but without having to risk more than you are prepared to on the premium. This is speculating with options trading where the upside potential could be better than the downside risk.
Speculation Scenario
A simple (and crude) example would be if you were to make a wager with a friend on the toss of a coin. You pay him £1 if heads, you receive £1 if it lands on tails. This event has a 50% chance.
Now, if you were able to take a ‘premium’ that you will pay 25p (25%) whether the result is either heads or tails, then you would be in a healthy situation. Lets look at the potential outcomes of this scenario
Coin Lands Heads – you would decline the option to lose £1, forfeiting instead the premium of 25p. Total outcome = loss of 25p.
Coin Lands Tails – you would fulfill the contract option and take your £1 profit, forfeiting the premium of 25p. Total outcome = profit of 75p.
As you can see (albeit crudely), the speculation then on the coin toss carries a lower risk than it does profit potential. Which, when the event as above being a simple coin toss carries a 50% chance of being either event, and an equal result weighting (£1) on either side, allows you to push the balance in your favour.
You will not find trades in options quite the same as the example above; this is just a representation of how traders may use options, or why they may.
If you as a trader feel that the premium does not reflect the reality of the outcome potential, it gives you an advantage, and thus a reason to speculate.
Hedging Options
Hedging is another reason why you may be considering options. If you own shares in a company directly, but would like to hedge your risk, options trading can fulfil that requirement. In this case, you can think of the options premium as similar to an insurance premium against price movements to the downside.
If you were to own 100 stocks that you had bought for £1,000 but wanted to protect against price drops, you could simultaneously trade an option on that stock so that you could both continue to keep the stocks and profit from the dividends and potential increase in price on your existing holding, whilst paying a premium to hedge your investment capital in the case of price drops. You would of course pay a price for that, but it can help to balance risk during periods of uncertainty.
Options Trading Flexibility
The flexibility when trading options versus traditional holding of assets is marked. Having the choice to fulfil, or not fulfil the contract, alongside having the option to profit from both drops, aswell as rises in market prices are very strong advantages.
There is also the flexibility of being able to use options in conjunction with traditional asset ownership as a means of making your risk management strategy and portfolio work the way you would like it to.
So now we know why people might want to start trading in options, we need to explore what the different options are and what they mean.
Options Trading Made Easy – Key Terms
Strike Price -The “Strike Price” is the price that you buy the option for. The fee associated with the purchase of the option is called the “Premium”. To make a profit buying or selling options, the strike price of your option has to be higher or lower than what you bought it for, including the premium.
Contracts – Options contracts are typically bought in multiples of 100 shares. For example, the premium to buy 1 stock is say 50 pence, you would have to purchase 100 of them for £50.
Options Premium – The price paid for the right to the options contract. To be thought of as similar to a deposit that is paid whether a contract is fulfilled, or not.
Option Duration – The length of time you have in which to act. Options durations can vary from hours through to years, the premium will usually alter for various durations.
Call Options – this type of trade profits when the price moves to the upside, facilitating traders going ‘long’.
Buy Call Options – being on the buy side of the option gives you the right to fulfil the contract, or not to. You would typically fulfill a buy call option when the price of the asset has moved above the option price.
Sell Call Options – being on the sell side of a call option means that you are providing the option in essence to another trader. You are the writer of the contract. In this case, you do not have rights to not fulfil a contract but are obligated to do so. Your loss exposure is also greater than that of the premium alone.
Put Options – this type of trade profits when the price moves to the downside, facilitating traders going ‘short; on an asset.
Buy Put Options – being on the buy side of a put option means you would have the right to fulfil the contract, or not to. You would fulfil your contract when the price has moved below the options price and withdraw when the price has not fallen below said options price.
Sell Put Options – when you are on the sell side of the put option, you are the writer of the contract and are obligated to fulfil. Your potential loss exposure as a ‘writer’ of the contract is greater than that of the premium, usually significantly so.
5 Potential Advantages of Options Trading
There are various potential advantages of trading in options. Whilst the list below is not exhaustive, it should cover most of the key advantages.
- Options trading allows you to trade stocks and other commodities without actually owning the underlying asset. You are still able to participate and profit (or loss) on securities usually with a fraction of the usual cost. In this case, you have a much lower initial start up cost.
- The flexibility of Options trading is a definite bonus, you are perfectly within your right to not execute the option if you feel like. Being given a time frame in which to execute your buying rights allows you to buy or sell the option any time before the expiry date, whether that be a few hours, a day, week, months etc. This flexibility allows you to maximise any potential profit and not lose out any opportunities.
- Options trading also offers the flexibility of being able to profit from both rises, and falls, in market prices. Traditional stock trading only allows you to benefit from the upside.
- You can use substantial leverage when options trading. The returns can therefore be amplified. This is a very attractive quality, and when used correctly much higher profits can be made in comparison to traditional stock trading.
- The potential risk can be lowered with Options trading as opposed to traditional stock trading because only the premium of the option is at risk, which is the price that you pay for the option, rather than the price for owning the actual stock. This can be a much safer option as the premiums are much lower than the purchase price of a stock.
5 Potential Disadvantages of Options Trading
With any type of trading, there are always disadvantages to the advantages mentioned. Finding the right balance between the two will surely maximise your profitability.
- The time limit on options may work against you, as you may be forced to buy or sell your option when the timing is not at the optimum price (if you are selling either side of the option).
- The high leverage that comes with options trading works both ways, if you are able to gain high profits, there is always a chance that you are able to lose just as much in the opposite direction if you are not careful with your risk management.
- Options are not as liquid as traditional trading, there is far less volume within options trading. This makes choosing an option to buy and sell slightly more difficult, and if you somehow manage to get stuck with an illiquid option, you will most probably lose money since you may not be able to buy or sell it. If you stick to highly liquid options, you can mitigate this.
- No physical ownership of the asset. Again this ties into the time limit, or option duration. If you hold a physical stock, the only time you ever actually solidify profits or losses are when you sell out of your position. All the movements in price are only paper profits or losses. Therefore, if you wanted to hold a stock indefinitely in the belief that the company has a solid longterm value, options trading cannot facilitate that goal aswell as direct ownership.
- The same lack of ownership during options trading can be applied as a negative for dividends. Dividend income investors will not be able to use options trading for that, unless using options as a hedge against traditional ownership.
In our next articles in the options trading series, we will delve a little deeper and take a look at the different types of options trading that are most typical and also some simple options trading strategies.
Want to know who to trade options with? Take a look here to find out who is rated best options broker.