In this post, let's dive into the world of options and the versatile nature of options trading!
What are Options?
Options are contracts that give asset owners the right to buy or sell an asset at a specified price at some point in the future.
From the financial market's perspective, these 'assets' could be stocks, futures, or Exchange-Traded Funds (ETFs).
Why options trading?
There are a few reasons why investors go into options trading. Generally, it is to express their opinion on the market, and:
Earn extra return as the market goes in their favor, or
Reduce risk as the market goes against them
Simply put, options trading is akin to an insurance transaction:
Options buyer pays a premium for protection under certain conditions, while;
Options seller earns the premium BUT has to honor the protection should the conditions are met.
Call & Put Options 101
There are 2 types of option contracts:
Call option: A contract that gives the owner the right, but not the obligation, to buy a stock at a predetermined price — called the strike price — within a certain time period.
Put option: A put option gives the owner the right, but not the obligation, to sell shares at a strike price before the contract expires.
What happens when you trade call and put options:
Call options:
Buying a call option: The right to buy an asset at a predetermined price (strike price) within a certain time period. [Cost: Pays a premium]
Selling a call option: The obligation to sell an asset at strike price within a certain time period. [Reward: Receives a premium]
Put options:
Buying a put option: The right to sell an asset at strike price within a certain time period. [Cost: Pays a premium]
Selling a put option: The obligation to buy an asset at strike price within a certain time period. [Reward: Receives a premium]
Trading call options from the point of view of asset owner
From an investor's point of view, selling call options is a way to limit his downside risk by earning a premium.
Example:
Investor owns asset XYZ at $50.
Assumption: Calls with a strike price of $50 can be sold for a $5 premium.
Let's say this investor thinks the price of XYZ is going to remain flat or move lower.
Acton plan: Investor can sell 1 call contract and get paid $5 in premium.
Outcome: Reduces downside risk when the price of XYZ drops, but upside is capped.
Scenario #1: XYZ drops to $40
As the price of XYZ drops to $40, the investor's loss is reduced thanks to the premium received:
Scenario #2: XYZ rises to $55
As the price of XYZ rises to $55, the investor that sold the call contract at $50 strike price now has the obligation to deliver/sell asset XYZ for $50 to the option seller counterpart instead of $55:
Trading call options from the point of view of a call options buyer that is bullish instead of bearish of the market:
From someone who is bullish on an asset instead of bearish, buying a call option is an effective way to express his/her conviction:
Example:
Asset XYZ is priced at $50.
Assumption: Calls with a strike price of $50 are available for a $5 premium.
Acton plan: Option buyer buys one call contract and pays $5 in premium.
Outcome: Capped downside and unlimited upside.
Scenario #1: XYZ drops to $40
When asset XYZ drops to $40, the option buyer's loss is capped at the premium paid - which is $5 in this scenario:
Scenario #2: XYZ rises to $70
When asset XYZ rises to $70, the option buyer has the right to exercise the call option at $50.
In other words, his gain is the price difference between $70 and the strike price of $50, minus the premium paid of $5, leading to a final gain of $15.
Trading put options from the point of view of asset owner
From an investor's point of view, buying put options is a way to limit his downside risk, or even make a profit while the price of the asset is going down.
Example:
An investor owns asset XYZ at $50.
Assumption: Puts with a strike price of $50 available for a $5 premium.
Let's say this investor is uncertain over the future of XYZ's price.
Acton plan: The investor can buy 1 put contract and pays $5 in premium.
Outcome: Reduces downside risk when the price of XYZ drops, with unlimited upside.
Scenario #1: XYZ drops to $30
When asset XYZ drops to $30, the investor who has bought the put option at $50 strike price has the right to exercise the put option by selling/delivering asset XYZ at $50.
By doing so, instead of making a loss, he made a gain while the price of XYZ dropped, with the only cost being the premium paid of $5.
Scenario #2: XYZ rises to $70
On the other hand, when the price of XYZ rises to $70, there is no incentive for the investor to exercise the put option which he bought for downside protection.
As such, for this case, the investor's loss is $5, which is the premium paid to buy the put option.
Trading put options from the point of view of an option seller
Option seller sells a put option contract to earn a premium. For the premium earned, the option seller has the obligation to buy an asset at the predetermined strike price from an option buyer when the conditions are triggered.
Example:
Asset XYZ is priced at $50.
Assumption: Puts with a strike price of $50 can be sold for a $5 premium.
Action: Options seller sells one put contract and gets paid $5 in premium.
Outcome: Unlimited downside with limited upside.
Scenario #1: XYZ rises to $70
As the put option buyer's strike price is $50, he will not enjoy any upside appreciation for the price of asset XYZ beyond $50.
Hence, when the price of XYZ rises beyond $70, the gain for the put option seller is capped at the premium received of $5.
Scenario #2: XYZ drops to $30
When the price of asset XYZ drops to $30, the put option seller now has the obligation to buy asset XYZ for $50, should the option buyer counterpart exercise his right.
In doing so, he had to buy asset XYZ at a more expensive price than the market price, earning a premium of $5.
Verdict: Using option contracts as a versatile way to express trade conviction/ideas
Now that we understand the basics of options and key concepts like call and put options, this opens up unlimited trading opportunities under different market conditions.
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Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
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