Most people are familiar with the basics of stock equity trading. The common position of buying a stock is when the owner is considered to be “long” the position. The “short” position is the owner selling shares of the stock to buy back at a lower price thereby making a profit when the equity price drops. The common way to avoid losing money on these positions is to use a “stop-loss” order which instructs the broker to sell or buy back shares at a specified level should the market move opposite the anticipated direction. Events such as the recent “Flash Crash” and subsequent ongoing market gyrations have proven that in some cases just using a stop loss order is not always enough to absolutely limit a traders liability.
Options as the name implies are Options to the ownership of the underlying asset. Today we want to look at a basic overview of options as an investment vehicle for traders who want to speculate in the markets but want to absolutely limit any liability they may have regardless of what happens.
Option strategies are varied and we will only cover some of the basics to familiarize newcomers with some of the techniques involved in trading with options.
It can be very handy to have a basic understanding of options as they are very versatile and available in an increasing number of markets. Today options are available on most Stocks, ETF's (exchange traded funds), Exchange Traded Notes, Futures and an increasing variety of other investment vehicles.
Many people gained their first exposure to options during the dot com run up in the 1990's where many companies started offering employees stock options as an incentive to retain talent. Of course this has existed for a long time for executives but became more common for the other members of organizations at that time. The theory is that if the stock goes up, everyone benefits and stock options could be “exercised” by selling them at different times based on tenure with an organization.Credit: Flickr
In terms of speculation simple outright long and short positions can be replaced using options by buying what are called “puts” and “calls”. These are options to buy or sell blocks of 100 shares of the underlying security. Options are priced by incremental “strike prices” in a listing called an option chain. The current price of the asset is called the “at-the-money” price and then the various strike prices are levels above and below that level.
One of the key benefits to using options is that since you do not actually own the underlying asset itself your liability is strictly limited to the price you pay for the option to own it. Another benefit of options is that they are not affected by wild gyrations in prices within the daily trading session which would stop out most holders of the underlying stock or commodity.
Because you do not actually have to own the underlying asset this makes more expensive investments available to people who may not normally have access to them. For instance to own 100 shares of IBM which is trading today around 191.00 would cost an investor 19100.00. With options, an investor who was so inclined could own an option on 100 shares to purchase the stock in 3 months time at 190.00 a share for 894.00. So for 894.00 you can control and benefit from the movement of 19 thousand dollars worth of stock for 894.00. This is tremendous leverage. If IBM should go to 100 the stock holder could be liable for the entire 9000.00 loss or how ever far it got before it hit the stop loss. The options trader is only liable for the cost of the option itself, or 894.00.Credit: Flickr
If you did not have 19000.00 in your trading account or at least that much margin, you would need to sell that option before the expiration day 3 months from now to avoid a margin call, and be forced to exit the position. The vast majority of the traders will exit option positions before expiration.
On all public regulated trading vehicles there is a stated buying price and a stated selling price that market participants are willing to buy or sell at instantly during market hours. The more people that are participating in the market the smaller the difference between these prices will become. This is referred to as the bid/ask spread. Most popular options enjoy great liquidity, meaning that there are many buyers and sellers and this keeps the bid/ask spread small.Credit: Flickr
In addition to this great liquidity and low cost of ownership, options are an incredibly versatile investment vehicle. Options can be used in conjunction with ownership of the underlying security in a variety of ways.
Options can be sold as well as purchased, so as an example we will look at a strategy known as a "covered call". If you own a stock and want to make additional income you can sell options against the shares that you already own. This is essentially a speculation that the price will behave a certain way and allow you to keep the “premium” or the amount that you sold the option for as well as your stock. If that should not occur, you will have to honor the agreement you made when you sold the option to buy or sell it at that price. For instance of you own 100 shares of IBM we discussed earlier and the current price is 191 and you sell the call option we discussed earlier for 894.00 at a 190 strike, should the stock be trading at 189 in 3 months when the option expires it would be worthless to the person who purchased the option from you because the trading price is not greater than the strike price of the call (i.e. 190 strike and 189 trading price) and you would be able to keep the entire premium and your stock. So although you stock did not increase in value, it did earn you a very nice return for keeping it in your portfolio for 3 months and selling an option against it.
If in the example given, the stock appreciates above the strike price of the call option sold, you have the obligation to sell it at that price. This is known as being "called away" from your position. Which can also be profitable to someone who purchased the stock at a lower price and now gains the difference between the purchase and the strike price as well as the premium from the option sold.
While these examples are very simplified, options strategies are virtually unlimited and can become incredibly complicated, and provide the potential to profit from any number of scenarios. Much time should be spent in studying these techniques before trying to employ them with your own money, but the time spent can pay you back many times over should you learn to employ them effectively.