Options trading, and specifically writing options, is normally poorly understood, and more often than not, poorly communicated. This article has been written to hopefully solve some of these common misconceptions and show that once educated in this area you will find you can actually work options to your favour to produce regular income and reduce your risk at the same time.
Options trading, and specifically writing options, is normally poorly understood, and more often than not, poorly communicated. This is why most people dismiss it as too complicated or too difficult. So many traders are put off trading in options purely because of lack of knowledge. But once educated in this area you will find you can actually work options to your favour to produce regular income and reduce your risk.
Options are just one type of Derivative. They’re a financial instrument which has another asset as its underlying base and includes futures and warrants. They provide exposure to shares but they deliver greater leverage and enable you to trade bullish or bearish markets and make money regardless of the direction the market is trending.
People trade options for the leveraged factor. For a minimal capital outlay you can generate great profit, but leverage is a double-edged sword. When you win, your profit can sometimes be ten times the amount the underlying share has moved, but when you lose your loss is magnified to the same extent.
There are two types of options, call option and put option. An option is a contract written by a seller that conveys to the buyer the right, but not the obligation, to buy (in the case of a call option) or to sell (in the case of a put option) a specified quantity of shares at a specified price (strike price) at or before a certain date in the future. In return for granting the option, the seller collects a payment called the premium from the buyer. A call option will rise in value exponentially when the underlying share rises in value and a put option will rise exponentially when the underlying share decreases.
You will hear plenty of horror stories about people’s experience trading options. Some of these stories may be based on truth, so it is important to know why people are sometimes repelled from trading options after being introduced to the market. Usually they have only employed a buying of options strategy, which is called directional trading and requires a high level of concentration and knowledge about where markets are heading because if your stock goes the other way to which you intended you will be at a loss, a leveraged loss at that also.
More investors lose money when adopting this buying of options only strategy. It is believed to be up to 80 – 90% of people lose money when buying options for directional trading. This is because the buyer needs their option to move further in-the-money to make a profit, and if it doesn’t they will be looking at a loss. In-the-money means the share price has to go up for a call and down for a put.
This is why it is imperative you explore the other side of options and see the advantage of being the seller. When you have sold another trader an option, you have put yourself in the enviable position of having sold a depreciating asset. The value of an option decreases exponentially the closer it gets to expiry, it will lose two thirds of its value in the last third of its timeframe.
Once an option has been purchased, if it is out-of-the-money (share price is below option strike price with a call option and above with a put option) at expiry, it will be worthless. The seller will have the money in their bank account and the buyer of the option will be holding a worthless asset. The buyer’s view of the option moving further in-the-money has failed.
There is one advantage though with buying options, but it is only when buying a put option to protect shares you already own. If you own 1000 shares for example you can buy put options to insure those 1000 shares at a strike price at or close to your purchase price. What that means is, if the share price is below your strike price at the time of expiry, you can automatically have those shares sold at your nominated strike price.
When used correctly options can definitely give you regular income as well as protection for your capital thus reducing your risk. But when used incorrectly, can quickly demolish your trading account.
