What is Options Trading?

What is Options Trading?

Introduction

What is Options Trading?

There are two significant ways you can trade options. The first involves buying the option itself and speculating on the price of the premium. The cost of the premium is going to fluctuate based on how the underlying stock moves so you can profit from these movements. For example, if you think a stock is going to go up, you can buy an in the money call, and as the stock rises, the intrinsic value increases as well.

Thus, you benefit from the rise in the overall premium value. With a put, as the stock falls, the intrinsic value of the put rises, and so does its premium. Remember, you’re buying a put to benefit from the price drop (you’re not selling a put). The second method of speculating options is not to pay as much attention to the premium.

What I mean is that you’re not concerned with the price rise in the underlying, you’re far more concerned with exercising the option. This involves an additional step, but if you aim to own the stock, then this could be a better method for you to deploy. Generally speaking, a lot of options traders don’t bother exercising the contract since the premium tends to capture the intrinsic value change pretty well.

Pretty straightforward so far, isn’t it? You can swing or day trade options like common stock, but these methods will need you to develop a directional bias in the markets. As we’ve seen, this increases your risk and is no different from usual trading activity. The point is, you don’t need options to trade this way. So how does one trade option intelligently?

Well, the best method to do this is to use the structure of the contracts themselves to isolate yourself from major market risk factors such as volatility. Often when swing or day trading, traders will use what is called a stop-loss order to limit their downside. This is a safety net only on paper since the market is liable to simply jump the stop loss level during times of high volatility.

So the trader is faced with more substantial than expected losses, and in some cases, such volatility might wipe out their entire account as well. Options avoid all this drama since you will only pay the premium upfront, thereby limiting your initial investment much. Next, you will be using ironclad contracts to protect your downside, and therefore there is no possibility of the market jumping the price. Even if it does, your contract specifies the price, so you will always receive the price as stated on it.

This being said, there are a few risks to options trading you should be aware of.

The Risks of Options Trading

Thus far, I’ve only been mentioning the trading of options concerning the underlying stock’s movements. If you think it’s going to rise, you buy a call. If you think it’s going to fall, buy a put. Well, can you short call or a put? Yes, you can, and this is precisely where the risks inherent to options trading enter the picture.

When you buy an options contract, your risk is limited to the terms of the contract. The person who sold you the contract receives the premium in exchange for selling it to you. They keep this premium no matter what. The seller of the option is generally called the writer.

Option writing has its advantages. For one, the majority of options traded tend to expire out of the money. If the contract does get used, this leads to a whole world of trouble. Think about this scenario: if you’ve written a call (that is, sold it), and if it moves into the money, your downside is unlimited.

Remember that when you’re writing a call, you’re betting that the underlying stock will not rise. Well, if it does arise, it can increase to infinite levels. What if your call’s strike price is at $10 and before the expiry date, the stock rises to $10,000? Unlikely, I know, but theoretically possible. The loss will easily exceed your account’s equity.

Writing a put doesn’t have an unlimited downside, but it does have a large one nonetheless. If the strike price of the put you wrote is at $50, your downside is a total of $50 per share (since the stock can decline only till 0). This is why writing options need to be carried out carefully.

So if the risks are this huge, why do people write options in the first place? Well, aside from the fact that option writing usually results in a profit (via earning the premium), most option writers cover their downside by covering their option positions. So if someone writes a call, they buy the underlying stock first. Another option is to buy a put at a lower strike price since this covers their downside.

You must understand the differences between writing options naked and writing them when covered. Naked option writing is the riskiest thing that you can do, and in fact, your broker will not allow you to do this. Covered writing is perfectly fine, and no broker is going to stop you from doing this.

I’m highlighting this because the strategies discussed in this book will require you to write options. You will need to be very careful when doing this and make sure that you execute the leg that covers the printed option first. This is not very difficult to do, but you do need to be aware of the possibility of implementing the strategy incorrectly.

In case you’re wondering, once you write an option, you can repurchase it at a lower price before the expiry date. In other words, you can short an option like you would a stock. Generally, with the strategies in this book, you won’t need to do this unless you adjust your trades.

Options have leverage inherent in them, and you should be aware of this fact. Every contract represents control over 100 shares of the underlying stock, so everything that happens is magnified by a 100x multiple. This makes it even more crucial that you execute your strategies flawlessly.

Other than this, options don’t present any risks. They reduce your risk of trading in the market thanks to minimizing the effects of volatility. Volatility is both a blessing and a curse for directional traders. On the one hand, it makes them money via massive swings. However, it’s not so much fun when the swings go the other way and wipe them out.