Options trading can bring impressive short-term profits, but investors should proceed with caution. Here’s what you need to know to decide if options are for you.
Once the domain of expert traders, options trading have seen increasing popularity among individual retail investors.
You may have come across some YouTube ads depicting option trading as something akin to a mobile game where your mission is to catch the falling line, or as the next get-rich opportunity that makes you money no matter which direction the market moves (that’s only half true, you’ll see why later).
The truth is a little more complex. You see, while options trading follows the fundamentals of stock trading, there is quite a bit going on in the background that you need to understand and be aware of.
Also, while options do have their benefits, they are also volatile and can incur unlimited losses – at least in theory. In the real world, you can always invoke bankruptcy to protect yourself from your creditors.
Startled? Good. Because options trading is not something that anyone should approach without both eyes fully open.
In today’s post, we detail (to our best ability) what you need to know about options trading.
Take this article as a starting point, but be sure to do additional research and talk to experienced traders before jumping in.
- What is options trading?
- Reasons why investors trade options
- Disadvantages of options trading
- How options trading really work: Case study
- Profitability: Buyers vs Sellers
- How to trade options in Singapore
What is options trading?
In a nutshell, options are a contract between investors that allow the speculation of share prices at a certain point in time. In other words, options let you bet whether the price of a share goes up or down. If the price moves in your favour, you’ll make a profit. If it doesn’t, you’ll take a loss.
As such, being able to reliably and consistently make profits trading options is highly dependent on your ability to accurately predict the movement of share prices. But more than just betting if prices would rise or fall, you’d also need to predict how much prices will change, and when.
Options have certain defining features, such as:
- Being a contract that exists between buyer and a seller
- Usually have 100 shares per option
- Has a premium: the cost of the contract, paid to the seller
- Has an expiration date: a time period during which the terms of the contract may be exercised
- Has a strike-price: the share price agreed upon
- No actual trading of any assets: investors often simply collect their profits instead of actually buying or selling shares
The most popular options involve shares, but options are also available for other assets, such as indices, bonds, exchange-traded funds, cryptocurrencies and commodities.
Before we delve deeper into options trading, let’s first clarify the difference between options trading and stocks trading.
Options trading vs Stock trading: What’s the difference?
|Contract that lets you bet on direction of stock price||Shares of ownership in individual companies|
|Can trade with relatively lower capital outlay||May require high capital to start trading|
|Higher risk, losses theoretically can be unlimited||Lower risk, losses are ultimately limited (share price drops to $0)|
|Short trading time frame (options expire as short as 24 hours, but can also last up to months or years)||Long trading time frame (you can buy stocks and hold them for decades if you wish)|
|Offers more flexibility; you are not obligated to act on the contract in certain circumstances||Less flexible; you can only buy, hold or sell|
|Suitable for advanced and experienced traders||Suitable for investors of most skill levels|
Reasons why people invest in options
Clearly, options trading isn’t for beginners (or the faint-hearted). However, if you know what you’re doing, options can be used to round out an investment portfolio.
Specifically, options trading can confer the following benefits:
#1 Hedge against share losses
Because options allow you to lock in a share price, you can use an option to limit your losses for stocks you own that are on a downward trend. In effect, this amounts to paying a small fee (the premium) in return for protecting against further loss in value.
#2 Start trading at lower capital
In order to start trading, options only require you to put up enough capital to cover the premium of the contract. In contrast, stock trading may require higher capital outlay. For example, an option for Apple shares may have a premium of $1,000 for 100 shares. In contrast, $1,000 will only buy you around 8 Apple shares from the market (share price at time of writing: USD125).
#3 Amplify your profits
On a related note, options can help you amplify your profits from trading. For example, if you have an investment capital of $1,000, you could buy 100 shares of ABC Inc at $10 per share. If the price moves up to $15 per share, you can sell your lot of 100 shares and make a profit of $500.
However, if you’d bought options at a cost of $200 each, with a strike-price of $10, you could buy five options with 100 shares underlying each option. Assuming that ABC share prices went up to $15, you’d make a total profit of:
$5 x 5 options x 100 shares – $1,000 capital = $1,500
#4 Gain more flexibility in your trade
As a holder of an option, there are several moves you can make within the validity period of the contract.
Depending on the circumstances, you can
- choose to act upon the terms of your contract (A.K.A exercising your option) to buy the shares at the strike-price to add to your portfolio
- exercise the option, buy the shares, then sell some or all of them
- sell a contract that looks set to be profitable to another investor
- sell a contract that looks unfavourable to another investor to recoup part of your losses
What are the disadvantages of options trading?
#1 Losses can be amplified
In the same way that options can boost your profits, they also expose you to amplified losses. This is because of the leveraged nature of the option trading, and exacerbated by the short-lived nature of most options. While there are tools and strategies traders can use to limit losses, it can be challenging maintaining a profitable position.
#2 Higher trading fees
Trading options may incur higher fees than trading stocks. Besides the standard broker flat fee per trade, option trades may attract an additional fee per contract. This means that the more contracts you trade, the higher your fees go.
#3 Requires in-depth knowledge and high amount of attention
Options trading is highly complex, and requires you to know what you’re doing. Primarily, you need to decide what direction the price will move, how much it will move by, and the time frame the move will occur.
In order to make anything approaching a calculated guess, you can imagine the amount of knowledge and expertise you’ll need.
How options trading work: A simplified guide
By now, you’re probably wondering how exactly do options work. To find out, we must first understand some important terms.
|Term||What it means|
|Call||Right to buy shares at the strike-price. You take this position when you think the share price will go up.|
|Put||Right to sell shares at the strike-price. You take this position when you think the share price will go down.|
|Holder||The party buying the option|
|Writer||The party selling the option|
Now let’s see if we can make sense of these terms with the help of a hypothetical scenario or two.
Let’s say the share price of XYZ Inc is currently at $50 per share. Investor Andy thinks the stock price will go up within the month. Investor Blake thinks the opposite: it will go down. So Andy enters into an options contract with Blake with a strike price of $50 per share and a premium of $2 per share (i.e, $200).
Because he thinks the share price will go up, Andy holds a call position, guaranteeing him the right to buy shares at the strike-price. Blake is the writer of the option.
We can break down the above scenario to:
|Duration||Till end of the month|
Now depending on how the share price moves, either Andy or Blake will make a profit with the other party taking a loss (options trading is a zero-sum game, there’s no win-win scenario).
Call position: Stock price rises higher than strike-price
At the expiry of the contract (ie, the last day of the month), the share price of XYZ rises to $55. This is $5 higher than the strike-price.
Andy exercises his right to buy at $50 per share, and buys 100 shares from Blake. Because he is buying the shares at lower than the market price, Andy makes $5 per share x 100 = $500.
As the seller of the contract, Blake owes Andy $500. However, because he was already paid $200 for the premium, Blake’s total loss is $500 – $200 = $300.
Result: Andy makes a profit of $500, Blake makes a loss of $300.
Call position: Stock price remains lower than strike price.
Now, what if the share price had gone the other way?
Let’s say shares of XYZ dropped to $40 at the end of the contract. Because Andy promised to buy at $50 per share, he would make a loss of $10 x 100 shares = $1,000. This is on top of the $200 he already paid Blake for the premium.
In this case, Andy can choose not to exercise his option, and let it expire worthless. He walks away with a loss of $200 (the price of the premium), which Blake gets to keep.
And because Andy has chosen not to exercise his option, Blake does not have to sell any shares to Andy.
Result: Andy makes a loss of $200, Blake makes a profit of $200.
The other half of the story…
Now, what happens if Andy was betting the share price would go down instead, but all other terms remain unchanged.
|Duration||Till end of the month|
In this case, Andy would hold a put position, which guarantees him the right to sell his shares at the strike-price.
Here are the possible outcomes then.
Put position: Stock price higher than strike-price
Let’s assume that once again, the stock price ends up higher ($55) than the strike-price ($50). In this case, if Andy sells his 100 shares to Blake, he would still have to top up $5 per share to match the market price of $55.
Since this would incur a further loss of $5 x 100 = $500, Andy would instead choose to let his option expire worthless, walking away with a loss of $200 (the price of the premium). Blake, as before, makes a profit of $200.
Put position: Stock price lower than strike-price
Let’s assume now the stock price drops to $30, which is lower than the strike price of $50. Andy exercises his right to sell his shares to Blake at $50 each. Blake has to accept the strike-price and pay Andy accordingly.
Now, Andy makes ($50 – $30) x 100 shares = $2,000 from the sale, minus $200 for the premium, for a net profit of $1,800.
Correspondingly, Blake makes a loss of $1,800.
Profitability is different for buyers and sellers
In our hypothetical examples, it seems that Blake has gotten the short end of the stick. His profits seem limited only to the value of the premium, while he risks much greater losses.
Andy, on the other hand, seems to have his losses limited to the value of the premium, while being able to enjoy much higher profits.
This is indeed true. Losses for option buyers are limited to the price of the premiums, which they pay to the sellers in order to enter into the contract. However, their potential gains are limitless.
For options sellers, their gains are capped at the value of the premium, while facing potentially unlimited losses.
Does this mean it’s better to buy options instead of selling them?
Not exactly. According to a study conducted in the 1990s, the odds of option trades being profitable for option sellers is a whopping 75%, while for option buyers, it’s around 25%.
Therefore, deciding whether to buy or sell options boils down to risk appetite: Would you rather have a 25% chance at earning high profits, or a 75% chance at earning lower profits?
How to trade options in Singapore
You can’t. At least not on the SGX.
Instead, you can only trade options on the US stock market and the most convenient way to do so would be via an online broker.
Follow these tips to help you choose a suitable broker.
Quality of research tools and educational materials
As we’ve noted above, options trading requires a high level of knowledge and awareness of the characteristics and trends of the sectors you’re targeting. As such, it is important to have a rich, well-researched resource library and tools at your fingertips. Choosing a broker that provides knowledge and important news can help you increase your chances of success.
Beware the fees
Options trades incur an additional fee per contract, which can quickly stack up and eat into your profits. Be sure to choose a broker with a clearly defined fee structure so you can estimate your charges and fees before trading.
Trading tools and strategies
To cope with the complexity and volatility of options, traders make use of strategies and tools to limit their losses and improve their outcomes. A good options trading broker should make such tools available to you – bonus points if they also include detailed instructions on how to properly use them.
Options trading is not for everyone. If you decide to take the plunge, be sure to set a strict budget, and never risk losses beyond your ability to cover. Use our comparison platform to find an online brokerage suited to your needs.
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By Alevin Chan
An ex-Financial Planner with a curiosity about what makes people tick, Alevin’s mission is to help readers understand the psychology of money. He’s also on an ongoing quest to optimise happiness and enjoyment in his life.