Trading using Stock Options

What are they?
Stock Options have been around since the early 70s, though similar in structure and pricing to the options we know today, options or more commonly referred to as ‘stock’ options are legally binding contracts that grant the holder the right to buy or sell an agreed quantity shares of an underlying stock at a fixed, predetermined price (strike price) in the future. Options can also be purchased on other underlying asset classes such as indexes, commodities, fx and many others.

How they are priced:
Stock Options are priced in a complex way, so that their premium (the price you pay) reflects market volatility as being risk to the option seller, much like the way that car insurance premiums vary from driver to driver, and they too reflect the individual driver’s risk, to which the car insurance company is exposed.
When a stock becomes very volatile, it is viewed by the option pricing formula as more risky, and therefore its option premium rise, so as to better reflect this increased risk from the perspective of the seller of the option.

Stock Options are characterised by their strike price and a Call Option makes money when the stock’s price rises above the strike price, whereas the Put Option makes money when the stock’s price falls below the strike price.

Options are priced by an overall premium, which is made out of intrinsic value and extrinsic value. An Option only has intrinsic value if the price of the stock has favourably passed the strike price level as explained earlier. The extrinsic value part is made out of the decaying time premium (options are decaying assets), and the implied volatility premium (or risk premium as explained earlier).

What’s unique about stock Options?
Most people tend to think that option trading offers great leverage, and limited risk, because when you buy options all you can lose is the prepaid premium. While this is true and options do offer great leverage if one trades stocks in the near term, they can only be profitable if the option starts to trade in the money (those that have intrinsic value).

Another great reason for trading options is their asymmetrical Risk/Reward ratio, if one for example trades deep in the money Call options on a stock they stand an overall better risk / reward ratio:

If the investor invests $10,000 in a stock, they stand to make a dollar for dollar gain or loss, depending whether the stock rises or falls.

With a deep in the money Call option, things are different, for example if the stock rises by $1, the investor will stand to make about $800, but if the stock falls $1, they stand to lose only $500. This is the asymmetrical R/R ratio of options, you gain $800 if things go well, but you only lose $500 of intrinsic on the downside.

Generally, options are hard to learn to trade because of their parameters and complexity, but once mastered they can offer a better alternative to trading stocks, or at least stocks on their own. Options contracts can have a lengthy expiry date, sometimes years in the future, and despite being decaying assets, if one buys in the money options, the time decay loss is minimised significantly, while gaining enormous leverage and better Risk / Reward ratio in their investments.

Turn Chaos into Cash

Many investors rarely protect themselves from unexpected events which indirectly impact the value of their portfolio – these events are referred to as tail-end risk. Such events as the credit crisis, earthquakes, wars etc are catastrophic events which can have both a human and financial cost. Like a car accident, we never expect or wish for these events to occur, but we protect ourselves by purchasing insurance each year, by chance an accident does occur.

Similar to car insurance, buying Put options can be viewed as insurance against the downward moves in the market. You pay a premium upfront for protection of catastrophic event, over a time period.

Buying options can be the cheapest and most effective way to protect your portfolio and/or make money from unexpected events. Out of the money options with a long maturity date is possibly the best way to do this and are particularly cheap during periods of low volatility. Out of the money options, are those which have a strike well below the current spot price e.g buying a 5000 put option on the FTSE, when the FTSE is trading at 6000, it becomes in the money if the index price moves below the strike of 5000.

During “uneventful” periods, volatility in the market falls and the price of an option becomes cheaper. This is probably the best time to take a sceptical view that something could happen in the future. With an option the maximum you can lose is the premium, so your downside risk is capped.

Some of the spread betting firms offer options on main indexes and stocks, but the price you pay does vary between them, so it pays to shop around for the tightest spread, in a similar way you would shop around for the cheapest car insurance.

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