Options are conditional derivative contracts that allow buyers of the contracts a.k.a the option holders, to buy or sell a security at a chosen price. Option buyers are charged an amount called a "premium" by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless and thus ensuring that the losses are not higher than the premium. In contrast, option sellers, a.k.a option writers assume greater risk than the option buyers, which is why they demand this premium. (Read more about: Options Basics).
Options are divided into "call" and "put" options. A call option is where the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. A put option is where the buyer acquires the right to sell the underlying asset in the future at the predetermined price.
Why trade options rather than a direct asset?
There are some advantages to trading options. The Chicago Board of Option Exchange (CBOE) is the largest such exchange in the world, offering options on a wide variety of single stocks and indices. (See: Do Options Sellers Have A Trading Edge?) . Traders can construct option strategies ranging from simple ones usually with a single option, to very complex ones that involve multiple simultaneous option positions.
The following are basic option strategies for beginners. (See also: 10 Option Strategies To Know).
Buying calls – long call
This is the preferred position of traders who are:
- Bullish on a particular stock or index and do not want to risk their capital in case of downside movement.
- Wanting to take leveraged profit on bearish market.
Options are leveraged instruments – they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if the underlying asset traded itself. Standard options on a single stock is equivalent in size to 100 equity shares. By trading options, investors can take advantage of leveraging options. Suppose a trader wants to invest around $5000 in Apple (AAPL), trading around $127 per share. With this amount he/she can purchase 39 shares for $4953. Suppose then that the price of the stock increases about 10% to $140 over the next two months. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5448, leaving the trader a net dollar return of $448 or about 10% on the capital invested.
Given the trader's available investment budget he/she can buy 9 options for $4,997.65. The a contract size is 100 Apple shares, so the trader is effectively making a deal of 900 Apple shares. As per the above scenario, if the price increases to $140 at expiration on 15 May 2015, the trader’s payoff from the option position will be as follows:
900*(140-127) = 11,700
Net profit from the position will be 11,700 – 4,997.65= 6,795 or a 135% return on capital invested, a much larger return compared to trading the underlying asset directly.
Risk of the strategy: The trader's potential loss from a long call is limited to the premium paid. Potential profit is unlimited, meaning the payoff will increase as much as the underlying asset price increases. (Learn more in: Managing Risk with Options Strategies: Long and Short Call and Put Positions).
Buying puts – long put
This is the preferred position of traders who are:
- Bearish on an underlying return but do not want to take the risk of adverse movement in a short sell strategy.
- Wishing to take advantage of leveraged position.
If a trader is bearish on the market, he can short sell an asset like Microsoft (MSFT) for example. However, buying a put option on the shares can be an alternative strategy. A put option will allow the trader to benefit from the position if the price of the stock falls. If on the other hand the price does increase, the trader can then let the option expire worthless losing only the premium. (For more, see: Stock Option Expiration Cycles).
Risk of the strategy: Potential loss is limited to the premium paid for the option (cost of the option multiplied the contract size). Since payoff function of the long put is defined as max(exercise price - stock price - 0) the maximum profit from the position is capped, since the stock price cannot drop below zero (See the graph).
This is the preferred position of traders who:
- Expect no change or a slight increase in the underlying price.
- Want to limit upside potential in exchange of limited downside protection.
The covered call strategy involves a short position in a call option and a long position in the underlying asset. The long position ensures that the short call writer will deliver the underlying price should the long trader exercise the option. With an out of the money call option, a trader collects a small amount of premium, also allowing limited upside potential. (Read more in: Understanding Out Of The Money Options). Collected premium covers the potential downside losses to some extent. Overall, the strategy synthetically replicates the short put option, as illustrated in the graph below.
Suppose on 20 March 2015, a trader uses $39,000 to buy 1000 shares of BP (BP) at $39 per share and simultaneously writes a $45 call option at the cost of $0.35, expiring on 10 June. Net proceeds from this strategy is an outflow of $38.650 (0.35*1,000 – 39*1,000) and thus total investment expenditure is reduced by the premium of $350 collected from the short call option position. The strategy in this example implies that the trader does not expect the price to move above $45 or significantly below $39 over the next three months. Losses in the stock portfolio up to $350 (in case the price decreases to $38.65) will be offset by the premium received from the option position, thus, a limited downside protection will be provided. (To learn more, see: Cut Down Options Risk With Covered Calls).
Risk of the strategy: If the share price increases more than $45 at expiration, the short call option will be exercised and the trader will have to deliver the stock portfolio, losing it entirely. If the the share price drops significantly below $39 e.g. $30, the option will expire worthless, but the stock portfolio will also lose significant value significantly a small compensation equal to the premium amount.
This position would be preferred by traders who own the underlying asset and want downside protection.
The strategy involves a long position in the underlying asset and as well as a long put option position. (For related reading, see: An Alternative Covered Call Options Trading Strategy).
An alternative strategy would be selling the underlying asset, but the trader may not want to liquidate the portfolio. Perhaps because he/she expects high capital gain over the long term and therefore seeks protection on the short run.
If the underlying price increases at maturity, the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price which he is holding. On the other hand, if the underlying price decreases, the trader’s portfolio position loses value but this loss is largely covered up by the gain from the put option position that is exercised under the given circumstances. Hence, the protective put position can effectively be thought of as an insurance strategy. The trader can set exercise price below the current price to reduce premium payment at the expense of decreasing downside protection. This can be thought of as deductible insurance.
Suppose for example that an investor buys 1000 shares of Coca-Cola (KO) at a price of $40 and wants to protect the investment from adverse price movements over the next three months. The following put options are available:
15 June 2015 options
The table implies that the cost of the protection increases with the level thereof. For example, if the trader wants to protect the investment portfolio against any drop in price, he can buy 10 put options at a strike price of $40. In other words, he can buy an at the money option which is very costly. The trader will end up paying $4,250 for this option. However, if the trader is willing to tolerate some level of downside risk, he can choose less costly out of the money options such as a $35 put. In this case, the cost of the option position will be much lower, only $2,250.
Risk of the strategy: If the price of the underlying drops, the potential loss of the overall strategy is limited by the difference between the initial stock price and strike price plus premium paid for the option. In the example above, at the strike price of $35, the loss is limited to $7.25 ($40-$35+$2.25). Meanwhile, the potential loss of the strategy involving at the money options will be limited to the option premium.
The Bottom line
Options offer alternative strategies for investors to profit from trading underlying securities. There's a variety strategies involving different combinations of options, underlying assets and other derivatives. Basic strategies for beginners are buying call, buying put, selling covered call and buying protective put, while other strategies involving options would require more sophisticated knowledge and skills in derivatives. There are advantages to trading options rather than underlying assets, such as downside protection and leveraged return, but there are also disadvantages like the requirement for upfront premium payment.