As the name would suggest, options trading can provide investors with greater choice and flexibility.
Options are a type of derivative that can be used to make money from both rises and falls in asset prices. They can be used for speculation or as part of a strategy to control risk.
Options are contracts giving the holder the opportunity to buy or sell an asset at a pre-determined price (strike) and date (expiration). The word “opportunity” is important as the holder is not under an obligation to exercise their contract rights. They can simply choose to let the contract “expire” unexercised.
Once a strike price has been reached, few options buyers execute the option and buy/sell the underlying asset (perhaps just one in ten do this). Instead, the option is sold, often with the option writer offering a good price to buy the options back, closing the trade. If the option never reaches its strike price, it becomes worthless.
Once you cut through some of the jargon associated with options trading, you should be better placed to gain an understanding of how options can be effectively used. The key thing to remember with any derivative is that you don’t actually own the underlying asset.
Contract rights come at a price, with the holders of options contracts paying a non-refundable fee known as a “premium” at the initiation of their contract.
This premium, and the value of the option, are determined by the stock price, strike price, time remaining until expiration (time value) and the price volatility of the underlying asset in question – all things we’ll cover. It is hugely complex and changes over time.
The key is that the value of the option tends to increase the more likely an event becomes and decrease the less likely it is. Higher volatility increases the likelihood of a specific strike price being reached, for example. Conversely, an asset that has not fluctuated much might see its option value decline the closer to the deadline (expiration) as it becomes less likely a sudden price change will occur.
The option premium paid is crucial to calculating the profit generated from options trading as most trades are closed with the buyer selling their option at a different value.
On the bright side, our maximum loss is always limited to the premium. However, the premium’s non-refundable nature means we still lose it, even when there’s been very little movement in the underlying asset price.
Long call options
Buying a call option, known as a long call, enables the holder to use options trading to profit from rises in a given asset. Long-call contracts on a company’s stock provide the opportunity to theoretically buy its shares at a given price and within a fixed time frame.
For example, assume an option contract gives the holder the right to buy 100 shares of ABC company at a price of £180 until 30 December 2017, and suppose the stock is currently trading at £170 as of 30 October 2017. The option premium happens to be £5 per share, so £50 per option (100 shares).
In this case, £180 is the so-called “strike” price, while 30 December 2017 is the contract “expiration”. If the ABC shares move above the strike price at some point up to the 30 December then there is the potential for the holder to make a profit by closing the option – selling at its new price.
However, to calculate the profit, the option premium paid at initiation of the contract must also be factored in.
In the example of ABC, 10 long-call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).
Suppose the ABC share price has risen to £190 as of 5 December, and the call options have more than doubled in price to £10.50 per share.
If we were to close the position at this point, our profit from options trading would be: (1,000 x £10.50) - £5,000 = £5,500
In this example, options trading has enabled us to greatly magnify the profit impact from a rise in the shares of ABC. Although the share price only rose 5.5%, we more than doubled our initial £5,000 investment.
Long put options
Buying a put option, or taking out a long-put contract, is the opposite of buying a call option. A long-put holder can use options trading to profit from declines in the underlying share price.
For example, suppose an option contract gives the holder the right to sell 100 shares of ABC at a price of £160 until 30 December 2017, and assume the stock is trading at £170 as at 30 October 2017. The price of the option, or option premium, happens to be £5 per share, so £50 per option (100 shares).
As in the earlier example, 10 long call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).
Imagine the ABC share price has fallen to £150 as of 5 December, and the call options have more than doubled in price to £10.50 a share.
In the money (ITM)
In the two examples above, the options contracts are said to have been in the money (ITM) as the underlying share prices moved in the direction that the contract holder had hoped for.
However, when a contract is ITM, the holder will not always profit from exercising the contract. This is because the premium paid at initiation must be factored into the equation.
For example, imagine in the previous options trading example of the long put that the share price had fallen to £156. Suppose the options are now priced at £4.50 per share.
If we were to close the position at this point, the payoff would be: 1,000 x £4.50 = £4,500
However, although the put options contract is ITM (the share price is below the £160 strike price) if we were to exercise the contract at this point we would make a loss. This is because the premium paid at initiation was £5,000.
(1,000 x £4.50) - £5,000 = £500 loss
At the money (ATM)
When an option’s strike price is equal to the underlying stock price, an options contract on a company’s shares is said to be at the money (ATM).
We would not choose to exercise the contract in this scenario as we would lose the entire contract premium that we paid at initiation. Up to the point of contract expiration, there is still a chance that the option contract will move into an ITM position.
Bearing this in mind, both volatility and time can be thought of as the friend of an option contract holder. When share price volatility is higher, and/or there is longer to go until contract expiration, the holder has a better chance of making money from options trading.
If the stock price remains unchanged or virtually unchanged by the time of contract expiration, the holder has still lost the contract premium.
Out of the money (OTM)
As the term would suggest, an out of the money (OTM) option describes the situation where an option contract has moved against the holder.
For a long call, this means the underlying stock price is below the strike price, while for a long put the share price would be above the strike price.