Options trading is a financial strategy that involves buying and selling options contracts, which are financial instruments that give the holder the right (but not the obligation) to buy or sell an underlying asset at a predetermined price before or at the expiration date.
Options are usually split into two types: “call” and “put” contracts. When you buy a call option, you’re paying for the right to purchase the underlying asset at a set price in the future – this price is known as the exercise price or strike price. On the other hand, with a put option, you’re buying the right to sell the underlying asset in the future at the agreed-upon price. The buyer pays a premium for this right, and the seller (writer) of the option receives the premium in exchange for taking on the associated obligation.
Options trading allows investors to leverage their capital and potentially achieve higher returns compared to traditional stock trading. With the right strategy, investors can profit from various market conditions, including upward, downward, or sideways movements.
There are two main types of options: call options and put options.
Calls (Long calls):
A call option gives the buyer the right to buy an underlying asset at a specified price (strike price) before or at the expiration date. If a trader believes that the price of a stock will go up in the future, they might choose to buy a call option for that stock instead of purchasing the stock directly. As we discussed earlier, option trading provides leverage, offering the potential for higher returns. In this scenario, if the trader’s prediction is correct and the stock price increases, they can benefit from the price movement.
However, if the trader’s prediction is wrong and the stock price decreases instead of going up, the only loss they will incur is the premium paid to purchase the call option. This limited loss is one of the advantages of using options – your risk is confined to the premium paid, and you are not exposed to the full value of the underlying asset.
Let’s see one example of traditional stock trading.
Example:
Let’s say a trader decides to invest $1000 in ABC Stock, which is currently priced at $50 per share. With that money, the trader can buy 20 shares ($1000 / $50 per share). If the stock price goes up by 10% to $55 in the next month, the value of the trader’s portfolio increases to $1100 (20 shares * $55 per share).
Without considering any brokerage fees or transaction costs, the trader’s net dollar return is $100 ($1100 – $1000), representing a 10% profit on the initial investment of $1000.
Explain same example with call option:
Imagine a call option for a stock with a strike price of $50, expiring in about a month, and it costs $2 per share or $200 per contract. With a budget of $1000, the trader can purchase five options for a total cost of $1000. Since each option contract controls 100 shares, the trader is effectively making a deal on 500 shares.
Now, if the stock price rises by 10% to $55 at the expiration of the option, the option becomes “in the money” (ITM) because the stock price is higher than the $50 strike price. The option is now worth $5 per share (the $55 stock price minus the $50 strike price), amounting to $2500 for the 500 shares.
In this scenario, the trader’s net dollar return is $1500 ($2500 – $1000), representing a 150% gain on the initial investment of $1000. This return is significantly higher compared to directly trading the underlying asset. The use of options in this case magnifies the trader’s returns, showcasing the leverage aspect of option trading.
Risk/Reward:
In this case, the trader’s risk is capped at the premium paid for acquiring the five option contracts, which is $1000. On the upside, the potential profit is unlimited because, until the option’s expiration, the stock price can increase without any upper limit.
Puts (Long Puts):
A put option is a financial contract that gives the buyer the right, but not the obligation, to sell a specified quantity of the underlying asset at the agreed-upon strike price within a specified time frame.
If you expect the price of a stock or investment to go down and want to profit from that decline with limited risk, you can consider buying a put option. This is the opposite of a call option. Unlike short selling, where the risk is unlimited because the price can rise indefinitely, with a put option, your risk is limited to the premium you paid to buy the option. It provides a way to capitalize on falling prices while having a known and controlled level of risk.
Example:
If an investor purchases a put option on Company ABC with a strike price of $60 and an expiration date of two months, they have the right to sell Company ABC’s stock at $60 within that two-month period. If the stock price falls below $60, the investor may choose to exercise the option and sell the stock at the predetermined price.
Risk/Reward:
The most you can lose with a long put option is the amount you paid for the option, known as the premium. While the potential profit is limited because a stock price can’t go below zero, similar to a long call option, using a put option allows the trader to magnify their potential return.
List of Options strategies
Options strategies are combinations of options contracts (Call & Put) designed to achieve specific trading objectives. These strategies allow investors and traders to take advantage of various market conditions and manage risk. Here are some common options strategies:
- Covered Call
- Protective Put
- Long Straddle
- Long Strangle
- Iron Condor
- Butterfly Spread
It’s important to note that each options strategy comes with its own risks and rewards. Traders should carefully consider market conditions, their risk tolerance, and the specific objectives before implementing any options strategy. Additionally, understanding the impact of time decay, implied volatility, and other factors is crucial for successful options trading.
Learn More: Successful option trading strategy
Pros and Cons of Options Trading
Options trading, like any investment strategy, has its own set of pros and cons. On the positive side, one of the major advantages of option trading is the potential for higher returns. Options allow investors to leverage their capital, meaning they can control a larger position with a relatively smaller amount of money. This potential for higher returns is particularly attractive to traders looking to capitalize on short-term market movements. Additionally, options provide flexibility, as they can be used in various strategies to profit from different market conditions, including bullish, bearish, or neutral trends.
However, option trading also comes with its challenges and risks. One of the main drawbacks is the complexity involved. Understanding the intricacies of options, including the impact of factors like time decay and implied volatility, requires a learning curve. Novice traders may find it challenging to navigate the options market without a solid understanding. Moreover, options have an expiration date, and if the market doesn’t move in the anticipated direction within that timeframe, the option may expire worthless, leading to a loss of the premium paid.
Additionally, the potential for quick losses is inherent in options trading, especially for those who engage in speculative or risky strategies. Overall, while option trading offers opportunities for strategic and leveraged trading, it necessitates a careful approach, continuous learning, and risk management to navigate successfully.