Tuesday, July 29, 2008

Why Trade Options?

Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:

One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.

When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;

  • The number of option contracts, multiplied by
  • The contract multiplier

The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.

This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;

  • Pay the option seller $75
  • If you decide to exercise your right and buy the shares, you will have to buy 500 (5 x 100) (100 being the contract size) shares at the exercise price of $25, which will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.

Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - . They have a free trial, so you can see for yourself whether penny stock trading is for you or not.

Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.

Limited Risk
One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.

A profitable trade
If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.

Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A losing trade
Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.

So, we will just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.

Limited Risk AND Unlimited Profit Potential
Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.

What are Options?

Definition: An option contract is an agreement between two parties to buy/sell an asset (stock or futures contract as an example) at a fixed price and fixed date in the future.

It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.

There are two types of option contracts - Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.

A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.

Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.

If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.

The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.

The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.

Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium - more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.

In the real world of exchange traded options, transactions don't really take place between two people like I've explained above. The process of Novation actually removes the identity of who is on the other side of the trade. You simply Buy or Sell an option contract from the exchange without knowing who is on the other side.