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:
Leverage
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 - <penny stock affiliate link>. 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 option pricing models.
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.
Insurance
Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.
One example of this is called a Protective Put. You can read more about option trading strategies under the Strategies link.
58 Comments
Scarlett January 10th, 2012 at 7:39am
Hi, the information is very useful. Thank you for this. I have one question: Do I have to own certain stock before I can buy the contract of Put Option for that stock?
Peter December 28th, 2011 at 4:00pm
Hi Patrick, yes, you can simply sell out of the options prior to expiration if you do not want to exercise and take delivery of the stock.
By the time the option reaches expiration the option will be trading at its' intrinsic value and hence there shouldn't be any difference in profits between the two scenarios.
Patrick December 27th, 2011 at 11:59pm
Hi. I know this question has been asked several times, but I'm not sure I've read a definitive enough answer to feel comfortable pulling the trigger on a call option buy. I want to purchase a boatload of call option contracts but will not have the cash to exercise the option at expiration. Do I just sell prior to expiration to avoid this? And is there any difference in profit between the two scenarios (selling option before expiration and exercising option at expiration)? Thanks!
Peter November 13th, 2011 at 11:32pm
Hi Jon,
Yes, you are correct with that example - your return is 9,900%.
At that point you can walk away with no more obligation. Your sell order on the option just closes the original long (purchase) position. Much like if you buy 100 shares and then go and sell 100 shares. After the sell you will have 0 shares. You would only have exercise risk if you sold the option without having an open long position first.
When you sell back the option, another participant (the buyer) will be on the other side.
Let me know if anything is unclear.
Jon November 12th, 2011 at 3:28am
Peter I have a bunch of questions that I just can't seem to find a clear answer for.
Let's say I buy 1 (American) call option with a $10 strike for 10 cents with no intention of ever exercising it. The underlying stock is announced to be bought for $20 and it immediatley goes from $8 to $20. The call option I bought is now worth $9.90 (after subtracting my premium)). This means I just made a profit of 99X my original investment, like a 9,900% gain. What I orginally paid for the option was $10 (.10x100). I sell the option for a profit of $990 (20-10.10=9.90, 9.90*100=990).
Can I just walk away after that with my profit?
Doesn't my sale of the call option that I previously bought count as a closing transfer and its not possible for someone to exercise the call option I just sold and force me to deliver?
I believe that just selling a call option is a type of short position so you would have the obligation to deliver if the buyer exercised, but it's not a short position when I sell an option that I already bought instead of just selling a call option outright?
I just want to make sure that if I sell a call option that I previously bought for a profit, I have no obligations whatsoever and can just leave the market with my profit. Since I wouldn't have enough money to buy hundreds or thousands of shares outright, but I have enough to buy options and I believe many people sell options that they couln't cover if exercised. And i'm also unclear on whether my call option gets bought by someone or just ceases to exist and the open interest will decrease?
Peter August 9th, 2011 at 5:56pm
Yes, you will make a loss on the shares as the buyer won't exercise unless the stock is higher than the strike price. However, it doesn't mean that you will have a total loss as you still have the premium received when you sold the option, which you will offset against the loss on the shares.
kanchan August 9th, 2011 at 9:53am
So that will be a loss to me right? Because I don't have the shares ...
Peter August 7th, 2011 at 7:36am
If it's a call option then you will have to sell the stock at the strike price to the option buyer. If it's a call option then you will have to buy the stock at the strike price from the option buyer.
kanchan August 6th, 2011 at 7:52am
And what if the person to whom I am selling the option exercises the option?
Peter July 26th, 2011 at 6:17pm
No, you don't have to buy it back - you can leave the position open until the expiration date. If the call option is out-of-the money then, yes, you will just keep the premium as your profit. However, if the option is in-the-money then you will be required to sell the stock at the strike price (but still keeping the premium already received).
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