Options
If you like the idea of the leverage you get with futures, but are concerned about the possibility of runaway losses, then you may find that options are more to your taste. Options, at least if you are buying them, will only cost you a certain amount and that is paid upfront. There is no more liability no matter how far the trade turns against you.
As you may have guessed from the name, options contracts give the buyer the option of buying or selling something at a certain price at some time in the future. So it’s similar to a futures contract to the extent that a future deal is defined in advance at a set price. However, as you have the option or choice of whether to go through with the deal, then you will only ‘exercise the option’ if it would make you a profit. It’s just because you have this choice that you have to pay for the privilege, so options cost money – you have to buy an option.
That’s the basics of options – they will always cost you something, a ‘premium’, which is gone for ever, but having paid that you don’t have to take any losses. The fact that you pay a premium means that you need to get a profit on the underlying price before you break even on the whole deal, but after that your potential gains are not limited, while your downside is already paid.
You have a lot of choices when you trade options. You can pick the price that you want for the underlying, and you can choose the expiration date, or “strike date”. These are factors in how much you pay for the premium. For instance, if the underlying is trading at $34, you may see a range of options for $30, $35, $40, $45, etc. The option to buy the underlying for $45 at the expiration date would probably be cheap, as it’s not very likely to make a profit, and will probably expire worthless. The option to buy at $30 would cost much more, as even if the underlying price doesn’t change, you have a built-in gain…. of four dollars.
Rather than spread betting, an alternative way of using leverage is through options trading. With options, you buy (or sell) the right to buy or sell a stock or index at a prefixed price up to a certain date in the future. The leverage arises from the choice of the prefixed price, which can be close to the current price or even far away. Buying an option gives you the right to execute the trade at the specified price, but not the obligation. In other words, if the price moves against you, you can simply let the option expire. Although options provide the right to buy or sell the underlying financial instrument, they are usually traded as standalone financial products. If allowed to expire, their cash value is typically returned to the holder.
For example, if a stock is currently priced at £5 per share you might want to buy the right to purchase the share some time in the future at, say, £5.50. Because the buying price is higher than the current price this option would be available quite cheaply, say 25p. All options have an expiration date. If your option has 12 months to run, then it might be reasonable to expect the share price to rise significantly. Suppose, then, that the share price reaches £6 by the expiration date. Then you can exercise your option. You effectively buy the share at £5.50, sell it for £6 and make 50p gain less the 25p cost of purchasing the option, giving a profit of 25p. In practice, rather than exercising the option and selling the share, you simply sell the option. Ordinarily, you would have bought say 1000 options, giving a profit of £250, less any costs. However, suppose instead that the share price crashed to £4 where it stayed until the expiration period of the contract. Then exercising the option would lead to a loss, so you then let the option expire. Despite the share price crashing badly, your only expense has been £250 for the options contract in the first place.
Now compare the situation with spread betting. The equivalent 1000 shares is £10 per point. In the first example the profit is £500 for a gain of 50p, less market spread and interest payments, for a net £450. In the second example, the 100p drop in the share price results in a net £1000 loss plus £50 dealing costs. With options trading, although the potential gain is smaller, the maximum loss is much reduced. Each of these strategies has their advantage and knowledge of them will provide additional trading opportunities, if you care to consider them. On balance, I personally prefer spread betting because the much reduced trading cost allows more frequent trading. Nonetheless, for those interested readers, here is a brief outline of options trading methods. Further details can be found elsewhere, First, however, I introduce some jargon, which is even more extreme than spread betting. You quickly get use to it when you trade regularly, so don’t be put off by it.
Options are referred to as ‘in the money’, ‘at the money’ and ‘out of the money’ depending on the price of the underlying compared with the contract price. For example, the $45 option is ‘out of the money’, and the $30 option is ‘in the money’. If the underlying was at the same price as the option contract price, then it would be “at the money”.
Up to now, I’ve been explaining the simple case of buying an option to buy something in the future. This is called a ‘call’ option, as you can call for the shares or underlying goods to be sold to you at the expiration. You can also buy a ‘put’ option, which gives you the right but not the obligation to sell the underlying at the expiration date for a certain price. This means that you can ‘put’ the shares with someone else for an agreed payment. This is similar to going short, in that you would look for the price of the underlying to fall so that you made a profit by forcing someone to pay you the contracted price, which would be more than the market price at expiration. So you can make a profit in a rising or a falling market, as long as you anticipate the moves correctly.
That may be all you need to know about options in your trading, and that is a way to use them to limit your risk to the premium, while having an upside without limit. There is a second aspect to options contracts, and that can also prove profitable although it can carry more risk. We’ll talk about strategies to minimize risk in the later option module, but for now you should consider that there is someone selling these options to the buyers.
There are two sides to each contract, and if you buy a call option, someone is taking your premium in return for guaranteeing they will supply you with shares at the option price in the future, if the shares are trading at a higher price. It is quite possible for you to be the seller rather than the buyer of the option, and pocket the premium in return for taking the risk. There are even ways you can mitigate the risk, one of the easiest being that you already own the shares, and so will not be open to big losses if you have to surrender them to the option buyer. This strategy is called the “covered call”, which means that you are covered by owning the shares if they are “called away” from you by the option buyer. If the price does not change in favor of the buyer, then after expiration you can sell another call option, and keep on doing this, generating a regular income. As long as you choose your option price carefully, the shares may never be called away.
You can also sell a put option, and you could use this if you wanted to buy some shares, and knew what price you wanted to pay, which was a bit less than the current price. You sell the put option at the price you are prepared to pay and if the shares go down to that, or below, then you will have to buy them. You were going to buy them at that price anyway, so if they go below there is no harm. And meantime you have pocketed the option premium.
Don’t worry if you don’t really understand those two strategies at the moment – it will become clearer when these and other ideas are discussed in a later module.
