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What is options trading? A beginner’s guide
Learn how options trading can protect your portfolio and enhance profits.
With COVID-19 coronavirus sending stock markets around the world plummeting, options trading is back in spotlight for being both a profitable and risky strategy when stock prices crash.
While trading options can be riskier than standard stock trading, when handled correctly by an experienced trader, it can also be used to protect stocks against losses and amplify profits.
Options contracts are derivatives investments, which means you’re exchanging contracts rather than buying and selling physical assets. While there’s always an underlying asset attached to the contract, such as stocks or commodities, you don’t need to actually own the assets at any point in order to make a profit.
This means that options traders can profit regardless of whether stock, commodity or forex prices are rising or falling.
In this guide, we cover how options trading works, the risks involved and how experienced investors can apply it to earn additional income from stocks.
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What is a stock option?
A stock option is a contract to purchase or sell a set number of stocks for a specific price, at a predetermined future date, from its seller. They’re popular among traders because they require comparatively less initial capital than stock trading and have the potential to earn greater amounts.
They’re unique from stock trading because it’s completely up to the buyer whether the contract will be executed. Say you have an options contract to buy 100 stocks of a stock before a certain date. Instead of buying the stocks and incurring brokerage fees, you could simply sell the contract on the market and take home the profits.
In fact, options traders rarely engage in the actual buying or selling of stocks – rather they earn profits from stock price movements. Although stock options are the most popular type of contract, you can also trade options on other assets such as indices, bonds, exchange-traded funds and commodities.
Options trading is not available on the Singapore Exchange (SGX)
In Singapore, investors usually trade options on the US stock market through online options trading brokers or the trade options alternatives known as “structured warrants” in the Singapore market.
Structured Warrants (SW) is the Singapore market equivalent of ‘Standardized Stock Options’ on the American market. It is an exchange-traded derivative that gives the investor the right but not the obligation to buy or sell the underlying asset at an agreed price (exercise price) on during expiration. SWs provides the opportunity for investors to profit in both bullish and bearish market and are available over a range of assets, including stocks and stock indices.
In this guide, we’ll discuss trading options on the US market as a Singapore trader.
How do you trade options?
The two main participants in an options contract are the “buyer”, who is the person that purchases the contract, and the seller of the contract, dubbed the “writer”. Whichever role you decide to take, you’ll first need to find a broker that offers options trading. The comparison table above shows some of the online trading platforms that offer this service.
There are two types of options that you can either buy or write. A call option gives its buyer the choice to purchase stocks from its writer at a specific price (aka the “strike price”) before a set period of time, or the “expiry date”. A put option is the opposite, where the buyer enters a contract to sell the stocks to the writer at a set price within a specific time frame.
For this reason, the buyer of a call option is hoping that the underlying stocks will rise in price, while the put option buyer is betting that prices will fall. The writers of the contract are hoping for the opposite.
What can you trade with options?
What is the price of an options contract?
One of the most important factors in an options contract is the premium price. This is the price paid by the buyer to the writer for the contract and calculated on a per-stock basis.
As an example, let’s say you buy a call option for 100 stocks at a stock price of $80 and a premium of $0.40. The buyer must agree to pay the stock price of $80 along with the premium price per stock, totalling $8,040 ($80.40 X 100 stocks) before the expiry date.
This means the buyer will only earn a profit if the stock price rises above $80.40 before the end of the term. As the expiry date draws close, the premium price will shrink relative to the stock price as it becomes easier to predict. If the stock price rises above $80.40, the buyer can sell the option contract on the market without buying the stocks or choose to buy the stocks at a discount price. Either way, the buyer makes a profit.
What are the broker fees for options?
The brokerage fees charged by brokers for exchange-traded options are usually higher than stock trading. For example, you’ll be charged a flat commission fee of USD$10.65 when you trade with TD Ameritrade, and an extra USD$0.81 per contract on top of the flat commission for options.
Many popular digital firms have eliminated base commission on options, stocks and ETFs.
Why do people trade options?
There are several practical ways that options trading can be used. First, by taking on more risk, you have the opportunity to earn higher profits than you ordinarily could through regular stock trading. Or alternatively, it can act as an “insurance” policy for your stock portfolio by offsetting losses if the market falls.
1. Options can amplify profits
Although it can be risky, options have the potential to earn a much higher profit than if you’d simply traded the underlying stocks. This is because the investment price (the premium) is much smaller than the price to buy stocks directly, but you can benefit to a greater degree from its price movements.
For example, if you believed the stock price of a company was going to increase, you could buy its stocks. If you bought 100 stocks at $40 and the price rose to $45 per stock, you could sell the stocks for a $500 profit, minus the brokerage costs. Your initial $4,000 capital has increased to $4,500.
On the other hand, if you had used the same $4,000 to buy $1 call options in the same company with a strike price of $40, you’d have the potential to earn profits from many more stocks. Since each options contract has 100 stocks, you would have purchased 40 contracts at $100 each, holding a total of 40,000 stocks. When the price of the stock increases to $45, the price of the contract premium also increases, although by a much lower percentage (see below).
This leverage means you can benefit from the premium price increase on 40,000 underlying stocks, instead of the stock price rise on 100 stocks in the first example. It’s important to note that while your profits would be significantly higher through options, any losses are also amplified (see risks below).
2. Options can protect stocks from loss
Investors can use put options to safeguard their stocks against a fall in the stock price. This is commonly referred to as “hedging”. For example, if the current price of Telstra stocks is $50.00, and you think it could fall lower in the future, you can purchase a put option to sell them for $50.00 each in the future.
If the price of the stocks falls in the future, the writer of the option will be obliged to buy them off you. If the price of the stocks rises, you can simply not exercise the option. In this strategy, the most you lose is the premium you initially paid – you’re not actually obliged to sell your stocks.
Fundamentally, you can also use a stock option to simply buy yourself time. You can lock-in the transaction price now and decide whether you want to go forward with it in the future. This strategy can be useful in times of high market volatility.
3. As extra income from stocks
If you think that the price of stocks you own is going to remain flat in the future, you can also write call options to boost your income. With this strategy, the buyer of the option believes that prices will rise and is agreeing to buy the stocks at a certain price point.
However, if (as you have predicted) prices remain flat or fall, the buyer will most likely not exercise their right to buy the stocks from you, leaving you with the premium they paid along with your stocks. This is similar to the previous strategy, where you’ve offset your losses, despite the value of your stocks dropping.
The risk is if the price of the stocks increases significantly, you’re now obliged to sell the stocks at a lower price than what they’re currently worth.
4. Market speculation
As with all other tradable financial securities, options can be used to speculate on the market. The price of a call option will increase if the price of its underlying security increases. Conversely, the price of a put option will do exactly the opposite. Each player – the buyer and a seller – is betting on the opposite occurring.
While this approach is risky and not recommended for new investors, you may be able to use the difference in risk exposure and smaller initial cost involved with options trading to diversify your portfolio, though you will have to take into account the complex risks of options.
What risks are involved with stock options?
It is important for investors to understand that options are a strictly zero-sum game. That is, in each transaction, one of the parties makes a gain at the expense of the other party. You need to make sure you fully understand the inherent risks involved.
The position you take through options will be a leveraged position. As such, a change in the price of the option is bound to be disproportionate to a change in the price of the underlying stock. The ratio of this change is represented by the term “delta”. Delta is positive for call options and negative for put options.
You may lose your entire investment
If the stock price changes in an unforeseen way, an option may completely lose its value. For example, your Telstra call options with an exercise price of $50.00 will be worthless at the expiry date if the stock price turns out to be only $49.00. Here, if you have purchased a contract with 100 units, you would have lost the entire premium you paid. This is a loss of 100%. In contrast, unless Telstra goes bankrupt, Telstra stocks will never become completely worthless.
So long as a Telstra stays afloat, there’s always a possibility that its stocks may increase in price over time. Since options have limited lives, they naturally decline in value at an exponential rate as they approach their expiry dates.
While the potential loss you can face as the buyer of an option is limited to the premium you paid, as a seller, your loss can be unlimited. If the buyer chooses to exercise the option, you will be obliged to deliver the purchase or the sale of the stocks at the preset price irrespective of their market value.
The takeaway message for beginner investors is that, ideally, options should be used to complement their current shareholding positions. Standalone positions should only be taken out after consultation with a broker or a financial adviser.
Franco-Nevada (FNV) call option
You can see an example of how a call option works from the writer’s perspective in this example on Franco-Nevada. FNV reached a new multiyear high on April 13, 2020. Imagine that as the owner of 100 stocks, you’re happy to lock in your gains at the high and you think the price could backtrack a little over the coming month.
The image above shows a list of FNV call options listed on Robinhood. Here, an investor can purchase a May 15th call option contract for $7.25 per option, totalling a cost of $725 with 100 underlying Franco-Nevada stocks. It gives the buyer the choice of purchasing 100 FNV stocks just below the current market price at $120 each on any date up to and including May 15th.
Now, let’s assume that you own 100 FNV stocks. As the writer, you will receive a premium of $725 from the buyer. But you will also bear the obligation to deliver 100 Franco-Nevada stocks to the buyer any time before and including May 15. Of course, you are predicting that the stock price will not be higher than the strike price of $120 during that timeframe.
On expiration day, let’s say that your prediction turns out to be correct and the stock price is $110. The contract is worthless for the buyer, because they can buy FNV stocks for $110 each on the open market. The buyer will end up not exercising the contract.
Accordingly, your total payoff from taking this position will be $725, which represents a guaranteed 6% return on the stocks you’ve put at risk.
On the other hand, if the stock price increased to $130, the buyer will exercise the contract. It leaves you to deliver 100 stocks for $120 each, receiving a total of $12,000. Yet if you were to instead sell the stocks at the market, you would receive $13,000 instead. As such, you would miss out on an additional $1,000.
Considering that you initially received $725, your actual lost opportunity cost would have been just $275 from this position. In percentage terms, this is an extra 2%.
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