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What is options trading? A beginner’s guide
This derivative can protect your portfolio and enhance profits. But note inherent risks.
While trading options can be riskier than standard stock trading, experienced traders may find it a way to increase profits and protect a portfolio against losses. Learn how options trading works, the risks involved and how experienced investors can apply it to earn additional income.
What is an option?
An option is a financial derivative — a term that refers to an agreement between a buyer and a seller that offers the buyer the right to buy shares of a particular stock, bond, commodity or other asset at a later date. Options are traded in contracts that specify the particular terms of your agreement, including an expiration date on which the terms of the contract expire.
Options are popular among experienced traders because compared to stock trading, they generally require less money up front with the potential to earn more. But it’s a double-edged sword: As you magnify your gains you also potentially magnify your losses.
Unlike stock trading, it’s up to the buyer whether to execute the contract before it expires. Instead of buying the asset set forth in your contract — and incurring brokerage fees to do so — you have the right to sell the contract for what it’s worth in the market and take any profits.
In fact, options traders rarely buy or sell assets. Rather, they earn profits from price movements.
The flip side to flexibility is the premium you pay for it: If the stock price goes nowhere or moves against you, the costs you pay to buy the contract could end up worth more than the contract itself.
How are options traded?
Options are traded on mainstream platforms, though your platform may limit the types of options you can trade if you’re just starting out. Brokerage accounts typically require you to request authorization to access options beyond the basic calls and puts. And each brokerage can use its discretion to determine how they approve you for those options.
Pricing for options is often different than pricing for stocks. For example, you could pay both a commission and a contract fee, depending on your brokerage. Other fees kick in if you hold the option to its expiration day.
How to trade basic options
You’ll want to first find a brokerage account that offers options trading and at a fee that fits your budget. You may need to set up your account for the type of options you want to trade.
Other steps depend on your brokerage but generally require you to:
- Narrow down the asset you want to trade. Its option chain allows you to see the options available.
- Select an expiration date. This date determines the option prices you see.
- Determine if you’re the buyer or seller. The buyer has the right — but not the obligation — to exercise the contract, while the seller has the obligation to deliver if it’s exercised.
- Decide between calls and puts.
- A call option gives the buyer the choice to purchase shares of the asset from a seller at a specific price — called the strike price — up to the contract’s expiration, with the hope the price will rise.
- A put option gives the buyer the choice to sell shares of the asset to a seller at a set price before the expiration, with the hope the price will fall.
- Enter your order. Options are typically limit orders, rather than market orders, which means you enter the maximum you want to pay to buy the contract or the minimum you’ll sell it for. Your order is executed if somebody on the other side of the trade agrees to your contract’s terms.
- Check up on your contract. If your order isn’t exercised, you may be able to update or cancel it without a fee.
How much are option contracts worth?
Each option contract entitles the option buyer or seller to an exact 100 shares of the underlying stock. How much an options contract is worth depends on the price of that underlying stock.
Four popular types of options contracts are:
- Buy 1 call option.
You pay a premium to purchase the right to buy 100 shares at the price listed on the option on the contract’s expiration date. If the price ends up below the list price, the option expires and is worthless.
- Buy 1 put option.
You pay a premium to purchase the right to sell 100 shares at the price listed on the option on the expiration date. If the price ends up above the listed price, the option expires and is worthless.
- Sell 1 call option.
You receive the premium up front by agreeing to sell 100 shares at the price listed on the option if the actual price of the underlying asset is higher than the price listed on the contract’s expiration day. If the price ends up lower than the listed price, you keep your shares and the premium.
- Sell 1 put option.
You receive the premium up front by agreeing to buy 100 shares at the price listed on the option if the actual price of the underlying asset is lower than the price listed on the contract’s expiration day. If the price ends up higher than the listed price, you keep the premium and buy nothing.
The basics of options pricing
An important factor in an options contract is the premium price. This is the price the buyer pays the seller — also called the writer — for the contract.
The premium price is calculated per share because, again, options contracts represent 100 shares of the underlying stock.
Say you buy a call option for 100 shares of Sasol (SOL) two months in the future at a strike price of R82 and a premium of R3.50.
The buyer must agree to pay the stock price of R82 along with the premium price per share — or R85.50 x 100 shares — on the expiration date. That means a total R8,550 for the contract.
- The buyer earns a profit only if the share price rises above R85.50 at the end of the term. At that point, they can choose to:
- Sell the option contract on the market without buying the shares
- Buy the shares at a discount price
How expiration dates affect premium prices
The amount of time left in a contract affects the premium price due to something called time value. In short, time value is the premium price less the stock’s intrinsic value — or the amount by which the strike price is profitable or not compared with the stock’s current market price.
As the expiration date gets closer, the premium price declines relative to the stock price as the price becomes easier to predict. That premium deteriorates the most in the final month of the option contract. So it’s possible to buy a slightly more expensive option with a longer date, considering the stock price rises early enough, and sell back the option on the market without losing much of the premium price.
Continuing our example, you could buy a R4 option that expires in three months and sell it back after the SOL stock price rises R5 to R87 — for R7.50, including the premium.
- You get the R5 appreciation in the stock price and sell the premium at R3.50, losing only the R0.50 between the R4 price. Here, your total profit is R450 — or a one-month gain of 112.5%.
- That’s a best-case scenario, however. The SBX price could have easily gone nowhere in three months, rendering your loss 100%.
How much will I pay in broker fees for options?
Fees come down to the brokerage you’re using to trade your options. Brokerage fees for options usually involve a per-contract fee in addition to a base commission. Other fees kick in if you hold your option all the way to its expiration or, in some cases, sell the contract back on the market.
Many popular digital firms have eliminated base commission on options, stocks and ETFs. Some don’t charge either a base commission or a per-contract fee. And still others no longer charge fees to exercise the terms of your contract.
What are the benefits of trading options?
Taking on risk gives you the opportunity to earn higher profits than you might otherwise through regular stock trading. It can also “insure” your portfolio by offsetting losses if the market falls.
Options can amplify profits
Although it can be risky, options have the potential to earn a much higher profit than simply trading the underlying share. This is because the investment price — or the premium — is much lower than the price to buy stocks directly, but you can benefit from its price movements.
If you believed the stock price of MTN was going to increase, for example, you could buy stock in the company. If you buy 100 shares at R51 — risking R5,100 in the trade — and the price rises to R56 per share, you could sell the shares for a R500 profit, minus any brokerage costs. In this case, you’d have grown your initial R5,100 capital to R5,600 — a decent return of almost 10%.
On the other hand, you could risk far less money and control more shares by buying a few call options. Two MTN contracts at R2 each would put just R400 of your money at risk and leverage twice as many shares. In this scenario, a R5 increase in share price could earn you at least R600 (200 x R5 – R400) — or up to R1,000, if you sold the options back and recouped some of your premium. Here, the return on your options have been between 150% and 250%.
Options can protect your portfolio from losses
Investors often use put options to safeguard their stocks against a fall in the share price. This is what’s known as hedging.
Say the current stock price for Vodacom is R130. If you think it could fall in the future, you could purchase a put option to sell them for R130 each at a later date. If the price of the shares fall in the future, the writer of the option is required to buy them from you. If the stock price rises, the option is simply not exercised and expires worthless.
With this strategy, the most you lose is the premium you initially paid, because you’re not actually obligated to sell your shares.
You can also use an option to buy yourself time by locking in the transaction price tooday and deciding whether to go forward with it in the future. This strategy can be useful in times of high market volatility.
Options can provide extra income from your portfolio
If you think the price of a stock you own will remain flat in the future, you can also sell call options to potentially boost your income. With this strategy, the buyer of the option believes that prices will rise and agrees to buy the shares at a stated price point.
This works best if you sell the call option priced slightly above the market price. So if prices remain flat or fall, the option is not exercised, leaving you with the premium the buyer paid along with your shares. This is similar to the previous strategy, where you’ve offset your losses despite the value of your shares dropping.
The risk is that if the price of the shares increases significantly, you’re now obligated to sell the shares at a lower price than what they’re currently worth, resulting in missing out on those potential gains.
Options can minimize the risk of a 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 increase if the underlying security decreases.
Each player — the buyer and a seller — is betting on the opposite occurring.
This approach is complicated and risky, and so not recommended for new investors. But the difference in risk exposure and the smaller initial cost involved with options trading can help you diversify your portfolio.
What risks are involved with options?
Options come with inherent risks and are strictly a zero-sum game: In each transaction, either a buyer or a seller makes a gain at the expense of the other.
The position you take through options is a leveraged position, and a change in the price of the option is bound to be disproportionate to the change in price of the underlying share. The ratio of this change is represented by the term delta. Call options are considered delta positive, while put options are considered delta negative.
How you can end up losing your investment
If the price of a stock moves against you, an option may completely lose its value. Let’s go back to our hedging example, where you’ve bought a call option on Vodacom with a strike price of R130.
- Your call option will be worthless at the expiration date if the share price turns out to be only R129. Purchasing a contract with 100 units, you would have lost the entire premium you paid — a loss of 100%.
It doesn’t mean that VOD shares are worthless. As long as Vodacom stays afloat, there’s always a possibility that its shares will increase in price over time. Because options have limited lives, they naturally decline in value at an exponential rate as they approach their expiration 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 are obligated to deliver the purchase or the sale of the shares at the preset price regardless of its market value.
The takeaway for beginner investors is that you should use options to complement your current stock positions or strategy and minimize your risks.
Done right, options can protect your portfolio, generate additional income or multiply returns for better or worse. But options are complicated and risky, requiring research to understand exactly how they work — especially if you’re new to trading. When you’re ready to get started, compare convenient trading platforms that support options. And note that options aren’t often included in a brokerage’s advertising of zero-commission pricing.
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