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Veteran traders would not normally favor either contract or an option over each other but would rather use them both.
Of course, it would depend on the situation as each of them has its own advantages and disadvantages. But you will still find some traders who will focus on either one of them.
It’s better to fully understand the characteristics of each one before you decide how to trade. Once you’ve done that, the rest is just a matter of using the strategies that you think would be more applicable at the moment.
What Is an Option?
The technical definition of a stock option is that it is an agreement between two parties where one (the seller or writer), gives another (the holder or buyer), a privilege in a specific stock transaction. Essentially, the buyer purchases the privilege or right to buy or sell stocks at a pre-agreed price within a certain period or specific date.
Stock options fall under the category of derivatives which means that their price comes from security, often an underlying stock. They are popular to companies and investors because of two major purposes: to hedge and to speculate. Speculators prefer buying options because they sometimes offer a chance for much higher returns – even outperforming the security they derive from.
The underlying assets could come in many forms such as stocks, stock indexes, commodities, precious metals, foreign exchange, etc.
Option – What Does It Mean? (Example)
A buyer may purchase a stock option on the shares of Company A for a strike price of $15 with an expiry date of August 24. It gives the buyer the right (but not the obligation) to buy Company A shares at $15 per share on or before August 24. After that date, the privilege disappears.
In this article, we will discuss more details about the various types of options, their advantages, and other worthwhile information.
Types of Options: Puts and Calls
- Call options. These are contracts that guarantee the right of a holder to buy stocks at a specific price by a specific date. In case the stock price does not meet the holder’s expectation before the expiry date of the contract, there is no obligation to purchase them.
- Put options. It is a contract that gives the holder the right to sell stocks at a predetermined price by a specific date. Under the contract, the seller must sell the stocks at the agreed-upon price. You may notice that the options do not carry the same risk. A writer (seller) assumes a different risk from a holder (buyer).
- Holders. If you buy a call or put option, you are in principle, buying just the right to purchase or sell the stock at a specific price. The potential for making a profit depends entirely on the difference between the share prices. If you buy a call option, you also get an unlimited potential for profit, but the downside potential is the premium that you will spend.
- Writers. If you sell a call or put option, you are primarily selling the right to purchase or sell to someone else. The upside potential is the premium for the option that you will get from the buyer of the option. However, it comes with unlimited downside risk.
To make it even simpler, if you buy an option, your downside potential is the value of the premium. If you sell a call, it comes with unlimited downside potential. If you sell a put, the downside potential is equal to the value of the stock.
Is Options Trading Better than Stocks?
Although stocks appeal to entry level and long-term investors, options trading appeals to active traders who are looking for greater flexibility. The associated time period for options is shorter and it can range from several days to months, making them ideal for investors who buy and sell regularly. However, options tend to be more riskier than stocks, and may not be ideal for beginner investors.
On the other hand, stocks are a good choice since they are less risky than options, and they tend to have lower expenses and allow for a hands-off approach to investing. Although there is no guarantee you will earn a return with stocks, the stock market has continually proved to be a stable long-term investment.
The percentage of Americans investing in stocks has remained steady since 1999, according to a report by Gallup. In 2020, only 55% of Americans invested in stocks, which is 10% lower than the share of Americans who held stocks in 2007. After the great depression, the percentage fell to 54% in 2011, and 52% in 2013. The levels have not risen beyond 55% in recent years.
Trading Options – Risks
Here are the main risks investors should be aware of:
Don’t forget that options are highly-leveraged investments, so expect their prices to move very quickly. Unlike stocks, you can see options prices moving by huge amounts in minutes or seconds instead of the usual hours or days like in stocks.
Let’s see an example:
Say a stock is currently trading at $15/share and you want to purchase 1,000 shares. This means you need $15,000 to purchase them. However, if you have the $15,000, but you purchase an option for the same 1,000 stocks at a price of $2 per contract, you can multiply the number of shares you can get. Since each contract gives you the right to purchase 100 shares, your $15,000 gives you the option to buy 7,500 shares. For the same amount of $15,000, you can get control over 7,500 shares instead of 1,000 shares.
Now, let’s move to 2 scenarios:
1. The company share price goes up to $20
- If you went with the first option, you’ll have 1,000 shares with a total amount of $20,000. This gives you a total profit of ($20,000-$15,000) $5,000.
- On the second option, you now have 7,500 shares with a total value of $150,000. Since you have already paid $15,000 to buy the options, you’ll pay $112,500 to buy the stocks (7,500 shares at $15 each) or $127,500. Your total profit in this case is ($150,000-127,500) $22,500.
2. Company share price falls to $10 (before option expiry)
- On the first option, you’ll end up with1,000 shares with a total current value of $10,000. Your total loss would $5,000 ($10,000 – $15,000).
- On the second case, you won’t use the option, meaning you won’t buy the shares since the current price ($10) is lower than the option you have to buy them in ($15). Your total loss would be $15,000 or equal to the amount you paid for the option.
|Purchase 1,000 shares||Option to buy 7,500 shares|
|Price up to $20||$5,000||$22,500|
|Price falls to $10||$5,000||$15,000|
With such factors like time until expiration and the relationship of the stock price to the option’s stock price, even the small movements in stock can greatly affect the movement of the underlying options. If the movement works against you, it could translate to huge losses in a very short span of time.
Complicated For Beginners
To begin with, there’s nothing simple about options trading – it’s a very complex arena. For one, an investor must observe the trades consistently as it goes through the market’s rise and fall just to look for potential opportunities to make a profit.
This and other similar activities are not for beginners who cannot perform meticulous technical analysis in trading options as efficiently as skilled professional traders. They should be familiar with so many strategies to adapt – and getting used to them takes time. Therefore, beginner traders must be cautious of a lot of things like market volatility.
This is not something that you can just plunge in and do when you please. It begins by applying for approval through your broker. Your broker will ask a series of questions about your financial capacity, investing experience and you grasp of the natural risks of options trading.
When your broker sees that you are ready, he will assign you a trading level that sets what types of options trades you can enter into. You should also keep a minimum of $4,000 in your brokerage account as the industry requires. You should take all these requirements into consideration.
Limited Timeframe For Success
Let’s face it: without a good opportunity coming around, futures options are a wasting asset. If you’re an options investor, you will be constantly looking to capitalize on a near-term price movement in your favor.
However, it should take place within days, weeks or months for the trade or contract to pay off. This means that your options’ value erodes as each day passes. This erosion accelerates as it gets nearer the expiry date. You can experience some frustrating events waiting for the right opportunity even as you have positioned yourself in the right direction of the trade. This can happen when the market doesn’t move far enough for you to make a profit leading your options to expire worthlessly.
Trading Options – Benefits
It’s easy to see the appeal that stock trading has to so many investors and traders. Options trading, likewise, has many advantages that also make it appealing for any prospective investor.
Perhaps its biggest draw is the potential to make money just by doing the activity without actually needing to have a significant amount of money on hand. This makes it ideal for starting investors with a small capital and easy to get into for those with larger funds to trade with.
The potential for big profits out of small investments stems from the use of leverage. It means that you can maximize the use of leverage to acquire more trading power from a small capital to optimize your returns.
There are traders who want to make money out of short-term and medium-term price fluctuations and usually hold several open positions at any time. For them, hedging poses an excellent means to manage risks. For example, one might choose to assume a particularly speculative position that may give him high returns but also the potential for high losses. However, if the trader wants to lessen his risk, he could give up some of the potential losses by hedging the position with another investment or trade.
The strategy allows the trader to be able to use one position to offset whatever loss the other position might get. If the original position ends up making a lot of profit, it could easily cover the cost of the hedge and still have some profits left over. If the original position ends up making a loss, the trader can recover at least some (if not all) of those losses.
Options trading can provide much more flexibility and versatility to investors because there are more opportunities that become available regardless of market conditions. They can buy and sell options based on a wide variety of underlying assets. Traders can speculate on the price movement of stocks as well as on the price movements of the other investment options such as indices, commodities, and foreign currencies. You can see from this that any interested investor would have a large number of good leads for a profitably-promising trade.
Perhaps you have a knack for closely predicting changes in the foreign exchange market plus a solid indispensable knowledge of a certain industry. Your predicting skills could be valuable in the forex market to trade options in foreign currencies and your industry knowledge could help you when you trade options on relevant stocks. There are limitless opportunities to find suitable trades for yourself.
There is also no shortage on the range of actual trading strategies you can use. To mention one, spreads provide true flexibility in the way you trade. The application is very wide: use it to limit the risk of taking a position, reduce the upfront cost of taking that position, or attempt to profit from price movements in several directions. Spreads bring in true versatility.
One key to success in options trading is to approach it with realistic expectations and a basic readiness. This way, you’ll manage your trades better and as a result, lessen your risks. A good rule to follow is to only put 3% to 5% of your trading funds into each trade. In case the trade goes bad, you won’t have the floor collapse from under you and you’ll still have substantial ammo left to try again and rebound from the loss.
One other great way to teach yourself about options trading is to paper trade before you use real money. Paper trading means trading “on paper” from beginning to end without investing your money. This is good for building some skills and confidence minus the risk of actual loss until such time you become very familiar with the ins and outs of options trading. You can do this easily through a virtual account at your online broker which often offers the service for free.
You can start trading options with just $100. However, there are some variables you must consider for your success. For a start, $100 is a small investment amount if you want to earn significant returns.
For example, if you invest 20% of $100 in a trade and the price moves in your favor by 0.2%, your income will be $20 * 0.002 = $0.04. As a result, you will need to have a robust strategy to move the tide in your favor.
In most cases, brokers will have minimum deposits to start trading, and this will determine how much you need to deposit to your account to start trading options.
Trading options cannot be considered gambling, which is a game of chances with no exact strategy on the wins or losses. Instead, the success or failure of options trading depends on the strategy you have employed, and not luck.
It also depends on your research, probably reading through finance and economic news, setting and analyzing indicators, consulting analytical forecasts, making openings with manageable margins, among other calculated moves. Generally, options offer a better way to minimize your risks.
There are many option trades that you can employ to maximize returns and minimize losses. However, your choice of option trade will depend on your investment style.
For instance, buying long-term equity anticipation security (LEAPS) matches a risk-averse trader profile. It allows you to get into a trade without committing the full premium. The iron condor, in contrast, is for risk-neutral traders. It gives you the right to get into a trade without knowing its direction.
For risk-tolerant traders, buying puts allows you to make profits when stocks pull back. If you are interested in speculation, synthetic long/short stock would be a better option.
Generally, the riskiest option strategy will depend on your risk tolerance and whether you will lean towards option writing or buying. When you write/sell the option, depending on whether it is a call or put, your odds of winning are high but limited to the premium price.
Though your chance of losing might be lower, losses are also unlimited. In contrast, buying options, whether call or put, your chances of making profits are lower, but profits are limitless as it depends on when the trade expires or on exit. However, on losing, you stand to lose the whole of your premium.