Options 5: Why Trade Options?
Options vs. Other Instruments
Option trading provides many advantages over other plain stock trading. Leverage,
limited risk, insurance, profiting in bear markets, each-way betting or market going
nowhere are only a few. But let’s look at a couple in more detail.
Leverage
One thing to note before we go on is that the buyer of an options contract pays
an amount, known as the premium, to the option seller. An option seller is also
known as the writer of the option. The option premium is simply the amount paid
for the option.
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When you buy an option contract from an option seller, you aren’t actually buying |
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Options give the buyer the right to buy a number of shares of the underlying instrument
from the option seller. The amount of shares (or futures contracts) to buy is determined
by;
The number of option contracts, multiplied by the contract multiplier (also called
contract size) is different for most classes of options and is determined by each
exchange. In the US, the contract size for options on shares is 100.
This means that every 1 option contract gives buyer the right to buy 100 shares
from the option seller.
So, if you buy 10 IBM option contracts, it means that you have the right to buy
1,000 IBM shares at expiration if the price is right (10 x 100).
Note: In other countries such as Australia, the contract multiplier for stock options
is 1,000, which means the every option contract you buy entitles you to 1,000 underlying
share contracts. So pay attention to the contract specs before you begin option
trading.
This also means that the price of the option is also multiplied by the contract
multiplier. For example, say in the above you purchased 10 options contracts that
were quoted in the marketplace for 15c, then you would actually pay the seller $150.
This is a crucial concept to understand. If you go out and buy 5 IBM share options
for 15c that have a Strike Price of $25, then you will;
Pay the option seller $75
If you decide to exercise your right and buy the shares, you will have to buy 500
(5 x 100) (100 being the contract size) shares at the exercise price of $25, which
will cost you $12,500.
In this case, your initial investment of $75 has given you $12,500 exposure in the
underlying security.
Option trading is very attractive for the small investor as it gives him/her the
opportunity to trade a very large exposure whilst only outlaying a small amount
of capital.
Say you bought a $25 call option for $1 while the underlying shares were trading
at $26. If the market rallies to $27 the option must at least be worth $2 because
you can exercise your right at $25. So, even though the shares only went up 3.8%
you DOUBLED your money because you can now sell back the option for $2.
Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks
are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it
is for Microsoft to trade from $25 to $50!
For this reason penny stock trading is becoming very lucrative for online speculators.
They can still trade the stocks outright as well as making massive returns if they
are correct about their view on market direction.
The only drawback with penny stocks is trying to pick which stocks to buy. I’m not
that familiar with trading penny stocks, however, I know of a great site that provides
stock picks for penny stocks every two weeks – <penny stock affiliate link>.
They have a free trial, so you can see for yourself whether penny stock trading
is for you or not.
Penny stocks can be risky though – there’s a reason why they’re so cheap, nobody
wants them! So, be careful to act on the right information.
Limited Risk
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One of the biggest advantages option trading has over outright stock trading |
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Remember our initial example of Peter buying a Microsoft Call option? Here are the
details of that trade provided with the appropriate jargon;
Underlying: MSFT
Type: Call Option
Position: Long (i.e. bought the contract)
Strike Price: $25
Expiry Date: 25th May
At the time of the trade, Microsoft shares (the Underlying) were trading around
$30. The Call option contract had been valued and was trading at $6.5 – known as
the premium, but more on this under pricing.
So, from the above information we can conclude that after the 25th May, if Microsoft
is trading above $31.50 we can make a profit on this.
Why $31.50? Because we paid $6.50 for the right to have this option in the form
of a premium to the option seller. This means we must consider this in our profit
estimate. Therefore we add the option premium to the strike price to determine our
break even point.
A Profitable Trade
If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise
our right to Call the shares from the option seller. Then we will be assigned Microsoft
shares at the exercise price of $25, which is the same as if we actually bought
Microsoft shares for $25.
Note: If we exercise our right and take delivery of the shares, this means that
we will have to pay the full amount for the shares. So, the number of option contracts
bought multiplied by the contract size multiplied by the exercise price. If you
are planning to hold onto option contracts until expiry and take delivery, make
sure you have the cash!
But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares
in your trading account with a purchase value of $25, yet they are trading at $40.
So, you can sell them at $40 and make $8.50 per share.
Why $8.50? Remember the premium we paid? We have to consider that with our profit
estimate.
Think about what happens as the underlying price continues to rise. You continue
to make more and more money once the stock price has exceeded the strike price.
But what about the downside risk?
A Losing Trade
Let’s imagine at expiration Microsoft shares are trading below our exercise price
of $25 at, say, $20. Will we decide to exercise our right and take delivery of the
shares and pay $25 per share? No way, because they’re only worth $20. So, we will
just do nothing and let the option contract expire worthless.
What have we lost though? We lose the premium that we paid to the seller, which
in this example was $6.5. That’s it. A lot less than if the stock plummeted and
we lost our entire investment.
What about if there is a stock market crash and Microsoft Shares are trading at
$5 at the time of expiration? The same as if the shares are trading at $20 – nothing.
We just let the option contract expire worthless and lose our premium – $6.5.
Limited Risk AND Unlimited Profit Potential
Can you see now how this type of strategy gives you the best of both worlds – both
limiting your risk and at the same time leaving you open to make unlimited profit
if the market rallies?
Not all option strategies have this payoff benefit. Only if you are buying options
can you limit your risk. For option sellers, this is the reverse – they have unlimited
risk with limited profit potential.
So, why would anybody want to sell options? Because options are a decaying asset,
which you can read more about under the Time Decay section.
Insurance
Another reason investors may use options is for portfolio insurance. Option contracts
can give the risk averse investor a method to protect his/her downside risk in the
event of a stock market crash.