Why Buy an Option?
You can see that options provide you with a bewildering array of choices for your trading, but options only go up to a certain date, and if the underlying doesn’t change as you think it should, then the option will expire worthless. This is unlike virtually any other financial security that you may find to trade on. Although you can win or lose in your trading, in some cases by a large amount, what is the attraction of a financial instrument where your money disappears entirely? Surely, you might be better off just buying the shares or other equity, and at least having some value left even if you are on the losing side?
When you choose options, you can achieve things that are not possible by trading in any other stock, commodity or derivative. An option is an extremely efficient way to be able to profit from share price movements. The price you pay for an option is a fraction of the share price, as you saw previously, yet you’re still able to profit to the full from the price move. Certainly, options are speculative as you don’t get anywhere unless the price moves in your favour, and even then it depends what strike price you have elected to pay for, but those who choose to trade on options believe that they can take advantage of these traits.
Time is critical when you’re trading options. It’s seldom worthwhile to buy an option with less than one month to run. Although the price of options may be more if they have longer to run, this is for the very good reason that it gives more time for the stock to move in your direction.
Selling an Option
Buying an option is the way that many traders decide to use this market. It has a distinct advantage that, even though you are taking a calculated position that may allow you to win much more than your premium, the downside loss is absolutely limited to what you have already paid out. There are not many trading markets in which you have this guarantee while still being open to leverage profits. But there is another side to options, and that is to be an option provider or “writer”.
While buying an option, whether a call or a put, limits your risk to the premium, you can also be the party selling the option and taking on the risk. This is also known as ‘writing’ the option. If you sell an option you have an obligation to fulfill the contract if the buyer decides to exercise it. You do not have any option or choice once you have decided to be the option writer. It must be this way because, as the writer of the option, you have received a premium in return for giving the right to the buyer. The point is that you receive the premium for taking on that risk. You may not have to do anything else, if the option is never in the money, and expires worthless.
After all, options trading is a zero-sum game. Combined, the buyer and the seller do not gain or lose any money from changes in value of the underlying (unless they separately take a position in it), the only profits and losses come from one gaining from the other. In every options transaction someone is hedging their position, and someone else is speculating, and they both cannot win at the same time. This is an important distinction from many other types of trading.
Some traders will tell you that buying options is the best way, while others will maintain that selling options can give you a good profit, with some strategies giving you a regular income. Selling options does not have to be all risk, as there are techniques to cover some parts of the possible costs. Neither way is always the best, as it depends on so many variables such as the amount of premium, the perceived risk, etc. As long as you know the pros and cons you can pick the strategies that work for you, and some of these are explained later.
These are the constraints and concerns that are on the minds of option traders. If you choose to spread bet on the price of options, you are removing yourself by one step from these direct effects, but you must always have these in mind when you are trying to determine the psychology of the market, and hence where the price is going to go.
Join the discussion