What is Options Trading - Explained simply.
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Hi, In this video we lay out an easy guide to understand the basics of options trading for a beginner.
Options are one of the most complex financial instruments to speculate with. Whilst financial markets themselves can be risky, options are many times riskier and therefore require expert knowledge to trade and master. Let’s quickly address the most basic part first. What are options?
Though it trades as a standard instrument, an option is basically a contract between two investors that helps them speculate on the price of an asset. This speculation can happen without actually owning the asset. Let’s understand this with an example.
Let’s assume a trader has a view on Tesla’s stock price three months down the line. We can call this trader a “Tesla Bull”. Tesla Bull thinks that the market is mispricing the stock and that the actual value of the company is higher, and this should be reflected in the stock price in three months. Mr. Bull wants to speculate based on his view but does not want to buy Tesla shares. He comes across another trader who has an opposite view on the company’s stock price. We can call this trader the Tesla Bear.
Tesla Bull and Tesla Bear enter into an agreement that lists their views, thereby providing Tesla Bull the right to buy the shares from Tesla Bear at a pre-determined price, this is called the exercise price.
So, for example, if the price agreed between both parties is $165, Mr. Bull has an “option” to buy the stock at $165 after three months. Now if the stock price at the end of three months is $190, the bullish trader stands to gain $25 from the agreement as he can now buy the shares at a lower price from the bearish trader. The bullish trader exercises the option and can sell the shares immediately at $190, carving out a nice profit.
On the other hand, if the stock price after three months is lower than the agreed $165, the bullish trader can choose not to buy shares at $165, because those shares are available at a better price.
But is this a bad deal for the bearish trader? He loses when the price goes up and doesn’t gain when the price moves down.
Well, not really. Enter “Options Premium”, which is an element in the agreement that will safeguard the interest of the Tesla Bear. There would be a “premium” amount agreed upon at the time of the contract and it will be paid by the Tesla Bull to the Tesla Bear for bearing the risk. This premium is non-adjustable and non-returnable, which means the bear keeps it irrespective of the outcome.
So, if the premium amount is $10, the Tesla Bull gains only $15 from the contract if the price closes at $190 after three months. Tesla Bear’s loss is also $15 as the $25 loss at the time of exercising the contract, gets covered by the $10 premium he received while entering the contract. On the other hand, if price closes below $165, the Tesla Bull loses the $10 premium, and the Tesla Bear gains the same amount as he gets to keep the premium.
In this example, the Tesla Bull will be termed as an “option buyer” and the Tesla Bear will be termed as an option seller. An option buyer has the right but not an obligation to honor the contract, and an option seller has an obligation to comply if the option buyer chooses to exercise his right. In the example, because the option buyer was bullish on the Tesla stock, the option he will use is a Call Option.
A Call Option gives the buyer the right to buy securities at a predetermined price. A bullish investor here buys the call option, while the bearish investor sells the call option.
On the other hand, if the option buyer is bearish, he can use the other category of options called “Put Options” to speculate. A put option gives the option buyer the right to ‘sell’ the security at a pre-determined price. So, for example, if the exercise price is $165 and the stock closes at $140 after three months, the put option buyer can still sell the stock at $165 to the option seller and pocket the cash. If, however, the stock closes above $165, the option seller gets to keep the premium.
But how is a ‘premium’ calculated? The premium of options is derived from three main factors.
One, the intrinsic value or the ‘moneyness’ of the option, which tells how much in-the-money the option is.
Two, time value of option, the further out the expiration date of the option, the higher its time value is.
Three, Implied volatility of the option, the more volatile the option, the higher its premium.
An option buyer has an unlimited upside and a defined downside because the most one can lose is the premium paid. On the other hand, the option seller has an unlimited downside and an upside limited to the premium received.
Beyond the basic explanation of options, there are several complexities that get added to this arrangement in the financial world, but that will end up confusing you as a beginner. Therefore, it’s best to understand options in its most basic form and build your understanding gradually.
In a decentralized and non-digitized financial world, entering into such contracts could be a nightmare for investors, you have to find the counterparty, decide on the terms of the contract and take the risk of the counterparty defaulting. But thanks to technology, all of this happens with the click of a button on most brokerages. All you have to do is to pick the asset you want to speculate on, pick the exercise price or strike price, and pay or receive the premium quoted on the exchange.
Next comes the real art – How to profitably trade options.
Trading any instrument requires a mechanism to foresee the movement in the price. This mechanism can be based on quantitative factors like charts and data or on qualitative factors like sentiments. For example, if your philosophy is breakout trading in stocks, you will become alert when the stock you are eyeing to trade is breaking out on the chart. Once the breakout happens you can buy call options and wait for the breakout to either work or fail. The important part here is that you need to monitor the price of the underlying stock and trade the options when certain trading conditions are met.
While trading the underlying stock is straightforward, trading Options is much more complex and riskier. You can multiply your capital but can also lose all the premium you paid. It’s worth noting that premiums can fluctuate considerably during the day based on the price of the underlying security.
So, if the premium you paid at the time of buying the contract was $10, when the price of underlying was $100, the premium could be quoting at $25 if the price moves by 20% to $120. That’s a 150% return on the premium paid, vs a 20% return on the underlying asset. On the other hand, if the underlying price goes down by 20%, the premium can see a 90% decline, this is the impact of leverage.
The bottom line is that a small movement in the underlying price can lead to a large movement in the option premium. This movement largely depends on three factors that we touch on earlier. This magnifying or leveraging can help option traders to be profitable with a small amount of equity, provided they have a system of positive expectancy. Therefore, having a system is the most important aspect of trading options. You can’t randomly buy and sell options and expect to be profitable.
To trade options successfully, you need to identify an underlying asset that you can track on a regular basis and understand its movement in and out. This underlying asset can be stocks, an index, commodities, or currencies. There are many finer aspects of trading options that you will learn as you continue trading options.
And finally, the most important aspect of options trading is risk management. Because of the magnifying effect of potential losses, the best options traders don’t risk more than 2% of their capital in one trade. As trades have the potential to go down to zero, large exposures can prove to be fatal for your trading account.
Such losses are sharp and quick and happen more often than one can imagine.
Remember it is best to start small while trading options and build a skillset that helps you generate profits on a consistent basis. After a lot of practice, you could have a decent trading system that throws trades on a consistent basis and is more right than wrong. It’s only then that you can expect to be a profitable options trader.
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