There is always an incentive to ‘stick with what you know’ when it comes to investments, after all, the only way to get good at something is to specialize, right? This is very true, but on the flipside, every form of investment is risky and anyone who tells you otherwise is not being honest. The risk of losing money while investing is very real, and this means that investors need to really concentrate on risk management if they intend to stay in the game for long, and this is where options contacts come in.
Options are a sophisticated financial instrument that possess all the advantages of investment, potential for huge profits, and the downsides, probability of losses. However, just like every other financial instrument: Forex, futures, stocks, etc., anyone can learn to trade options and make money doing it.
How options work
In the past, we have looked at binary options – their history, functioning and how to use them, but options are quite different. In a way, you might say that binary options are a simplified version of options contracts, and here’s why - options and binary options are both instruments for speculating on the future price movements of underlying assets like stocks, currencies, etc. However, that’s where the similarities end, because options work in a different way.
An option is simply a contract between the buyer of the option and the seller of the option who owns the actual underlying asset which could be a commodity, stock or any other financial instrument. This options contract then provides the buyer with a right to buy or sell the seller’s asset at a specified time in the future, but it does not force the buyer to do so. In other words, the buyer has the option to sell or buy the asset if he still wants to when the time comes.
I understand that it may still not be very clear, so here’s a hypothetical scenario – say, it’s a few weeks before the US elections and we all know how that can affect trading, and you believe Hillary Clinton will win the elections based on the polls, causing the stocks of an ammunitions company to drop. This company’s stocks are currently trading at $50 per share, and you could simply sell the stocks right now and wait for them to drop, but you don’t have enough capital to make a huge enough investment that could bring a huge return.
Options can help you overcome this hurdle; since you believe strongly that the shares will drop, you go to an options exchange and buy a put option. This option allows you to sell the stock at $45 a month after the elections, regardless of how much the price of the stock declines. You also pay a premium to the options writer of about $100 for the options contract. Come election day, Hillary Clinton loses the elections and the company’s stocks soar to $60. The options contract is essentially worthless since exercising the contract would leave you at a loss, and you choose to let the contract expire.
If, on the other hand, Donald Trump had lost, and the company’s shares dropped to $40, you could have closed the position and sold it at the specified strike price of $45, minus the current market price of $40 making a $5 profit on each share. Since every options contact represents 100 units, in this case, 100 shares, you would have made a $400 profit ($500 minus the $100 premium).
As you can see, the options contract provided the buyer a right to sell the stock, but you didn’t have to and could choose to let it expire. However, the seller of the option has the obligation to perform his duty even if it might cause them a loss.
From the example above, there are a lot of terms mentioned that you need to understand if you’re going to be trading options:
- Put and call – a ‘put’ action is similar to a ‘sell’ action in the Forex market, and is used when the investor believes the price of the underlying asset will decrease. The ‘call’ action is the opposite, and is used if the buyer thinks price of the asset will rise, similar to a ‘buy’ action
- Writer or seller – this is the other party in the transaction who owns the underlying asset. As we have already mentioned, they are obligated to fulfil the actions declared in the options contract since it was they who offered the option
- The buyer – the individual who purchases the options contract from the seller. They only purchase the right to exercise the option on or before the expiration date
- Expiration date – an options contract must specify the date on which it becomes void. This could be days, weeks or months from the date the option is purchased and is agreed upon by the buyer and seller. Until the expiration date passes, the buyer of the option can exercise their position at any time and the seller must comply
- Strike price – this is the price stipulated in the options contract that the buyer will either buy or sell the asset at in the future
- Options premium – this is the cost of purchasing the option, and can be considered by the buyer as the risk capital or investment cost. Calculations of the options premium are complicated, but they are up to the writer to determine depending on the current value of the asset, time period of the option and implied volatility of the asset depending on market sentiment. It’s not important for you to know how these premiums are calculated, as long as you know how to determine if it’s reasonable, which we shall look at in the next section
- Exercising – the option is only valid until the expiration date passes, and the buyer can choose to enforce what the options contract dictates. This is called exercising the option because the buyer is exercising the right they have on the underlying asset
What to consider when trading options
To determine whether an option is worth buying, you only need to consider the market value of the asset, premium of the asset, time and expected volatility during that time, and finally the commissions charged for the option.
Take the example above: the market value is $50 and the premium $1, but a standard options contract has 100 units, hence a $100 premium, and a $45 strike price. In order to make money out of this option, the value of the stock has to fall below $44 ($45 – the $1 premium), and this is where the asset’s volatility comes to the fore. You need to be certain that the value of the stock will fall below $44 within the stipulated price in order to make any money out of the trade. Besides, there are usually commissions charged for options, so you should be thinking of about $40 or lower for the trade to make any sense.
Before purchasing an option, therefore, you really have to consider if you can be fairly certain that you will see this amount of change in the given time. Don’t go rushing into an options contract before considering the costs and the sentiment about the asset in the short and long term.
How to trade options
We have already mentioned call and put actions in regard to options, but there are 4 main actions that can be performed with options. To simplify these terms, you only need to think of these terms from a Forex trader’s perspective where going long means buying and shorting means selling.
This is an action to buy a call option, and is used when the buyer believes the price of the asset will rise. These transactions can be made by a speculative trader who only wants to make a profit on the asset’s value without actually owning the asset, but it is also used by investment companies who would like to ensure that they can acquire a certain asset at a desired price instead of waiting for the markets.
This is an action taken by a party offering an option if they believe the asset’s value will decrease by the expiration date. Usually, it is an individual or company actually owning the asset, but speculators can also perform short calls. If the speculator offering the option does not own the stock, they could settle the difference with the buyer using a cash pay-out. If the buyer insists on the physical asset, though, then the seller must buy it at the current market price and fulfil the option contract which makes him obligated to sell the asset. In short, it’s the other side of the coin to a long call.
When a trader buys a put option, they expect the asset’s value to fall and make a profit from the price change. The trader is not obliged to buy the asset, and they can let the option expire, but they still need to pay a premium for the option.
When one party makes a long put, the other makes a short put, which means they believe the value of the asset will rise. The party making the short put is essentially the seller of the option and is obligated to act upon the option’s specifications, whether it’s good or bad for them. Just like a short call, the seller must settle the option’s stipulations either by a cash pay-out or by delivering the actual asset at the market price.
How to access options
Options have been around for a very long time, although they have only become mainstream in recent decades. They also come in many forms:
Through an exchange
Just like stock exchanges such as the NYSE, there are also exchanges dedicated to the offering of options. The largest and oldest of which is the Chicago Board Options Exchange (CBOE) created in 1973. There are plenty more such exchanges around the world where individuals and companies can purchase these options, and these exchanges must be regulated by the region’s financial regulator
These are basically agreements between two parties, one who becomes the writer and the other the buyer. These kinds of options agreements are the ones which have been around for centuries unlike exchanges which were only recently implemented, and they can be on anything. Options are not restricted to financial instruments, but can be on anything from real-estate, art to personal belongings. Nevertheless, notarization is still required to make the option enforceable, otherwise the writer might decline to exercise the option.
These over-the-counter options have become quite complex nowadays, whereby the holder of an option can then sell it to someone else. Such secondary purchases of options have become very common and become a market all on their own where individuals simply purchase options just to resell them and not having to wait for the expiration date.
Besides over-the-counter options, it may be difficult to get access to the options offered by options exchanges, which is where the brokers come in. these are companies with an online presence and access to these exchanges who can provide the options to individual traders worldwide.
Some Forex trading brokers from the independent list have also started offering this service, and can be easily found online, but CFD trading Forex brokers almost always offer options since they deal with derivatives. However, unlike exchanges which are regulated by financial bodies or over-the-counter options which are notarized, the only way to determine a broker’s legitimacy is to check if they are registered by the relevant Forex regulators.
Why trade options
Options can be a great addition to any trader’s portfolio because not only is it profitable, it can be used for hedging thereby providing the investor with security for their investment. Besides, once you learn how to work with options, you may find them to be very appealing because of their unique features. They may also seem quite complicated, and they are a bit complicated, but with some practice and consideration of all the information in this article, you might become an options expert.
Watch this short video with illustrations to help you understand options even better: