I used to day trade options with my personal investment account. I stopped after 6 months, not because I was losing money, but because it was too time-consuming and I couldn’t monitor my positions in real-time while having a full-time job.
I closed my account with 10% profit for myself… and 10% profit for my broker as you can read in the post “Can I Make Money Day Trading?“. The aim of these upcoming options trading posts is to present options from a practitioner’s point of view, not only from a theoretical textbook perspective.
On a daily basis, I work with institutional options traders at the major banks. Even though the way they make money trading options will differ from the way an individual would, it is still interesting to get the full picture and understand how the options market work.
Unfortunately, most people don’t have the adequate knowledge to trade options and should stay away from them. But if you were planning on trading options, you really need to know what you are getting yourself into. I will try to explain complex concepts in a simplified way.
Once you understand how options work, you can decide whether to trade them or not. I am not a financial advisor, I am only putting together useful information so you can make your own decisions.
An option is a financial instrument giving its holder the right, not the obligation, to buy or sell another underlying financial product at an agreed time in the future, for an agreed price. In order for the option holder to obtain this right, s/he has to purchase it by paying the option price (the premium) to the option issuer.
The future agreed time to exercise the right to buy or sell is called the maturity of the option (e.g. in 3 months time). The future agreed price to buy or sell the underlying financial instrument is called the strike of the option. Both maturity and strike values are agreed between the buyer and the seller of the option when the transaction is dealt (day 0).
An option is a derivative product because it relies on another financial product (the underlying) in order to exist. The underlying itself can be any financial product or commodity (e.g. equity, bond, foreign exchange rate, oil barrel, etc…).
A call option is the right to buy the underlying. A put option is the right to sell the underlying. In addition, you can either buy or sell the option itself. So there are 4 different payoffs with these vanilla options:
- Buy the right to buy (long call)
- Buy the right to sell (long put)
- Sell the right to buy (short call)
- Sell the right to sell (short put)
Trading the Underlying versus Trading the Option
To better understand the outcomes of trading options, let’s consider a traditional Microsoft equity stock, currently valued at $36 a share. You can buy the share today for $36 and if it goes up to $40 three weeks later, you can resell it at that future time and make a $4 profit (excluding any fees).
Or you can decide to hold the stock longer and wait until the share price goes higher so you can resell it for a larger profit. On the other hand, if the stock value tanks and never trades above $36, you can keep it and wait for better days. In the meantime, you will collect dividends if any are paid. That’s basic stock trading.
Now, let’s assume you’d rather trade options on the Microsoft stock. Instead of buying the Microsoft stock, you buy the right to buy the Microsoft stock in the future (long call). For instance, you purchase a 3-week call option on the Microsoft stock with a strike of $36. For this investment, the premium you will pay for the option is about $1.50. By the way, all these numbers have not been invented, they are directly taken from the financial markets (e.g. Yahoo Finance).
Three weeks later, if the Microsoft stock is trading at $40, you hold a winning position. You can exercise your call option to buy the Microsoft share for only $36 (strike price) when it is really worth $40. If you immediately go and resell the stock at $40 on the financial market, you have made a profit of ($40 – $36 – $1.50) = $2.50 as you need to also subtract the $1.50 premium you paid for the option.
On the other hand, if the Microsoft stock is trading at $30 three weeks from now, you will not exercise the call option and will let it expire. There is no point in buying the share for $36 when it is only worth $30. If you really want to purchase the underlying Microsoft stock, you only have to pay $30 to buy it directly from the stock market. Letting the call option expire will imply a loss of the $1.50 premium.
In summary, we assumed the stock currently trades at $36, which is also the strike of the call option. In the winning situation for the buyer, the future stock price (the forward price) in three weeks was $40. In the losing situation, the stock would trade at $30 in three weeks time
If we were trading stocks, we would have made a profit of $4 and would have kept the stock otherwise, waiting for a more advantageous situation in the future (unrealised loss). If we were trading options, we would only have made a profit of $2.50 and would definitely have lost $1.50 if the price was below $36 three weeks after (realised loss).
Why Trade Options?
So why are people trading options seeing as they seem to be worse off in terms of profit and loss compared to trading stocks in the exact same market conditions? The answer is different for corporations and financial institutions. For single individuals, I personally believe this is driven by greed and gambling appeal. I have traded options and had those feelings which I will detail later on.
For corporations and financial institutions, options are mainly used as a hedge, an insurance policy, not to speculate. For instance, Qantas needs to buy fuel for its planes and is therefore dependent on the oil barrel price fluctuations. This creates uncertainty in their financial forecasts. If the oil barrel price suddenly skyrockets, it will increase their expenses and bring down their profits. So they will be looking for a way to limit that unknown variable.
In their case, let’s assume they buy 6-month call options on the oil barrel at a strike price of $90. If in 6 months, the oil barrel is trading at $120, they can still buy what they need for only $90 a barrel. If the oil barrel is trading at $50, they will buy it directly on the commodities market and let the options expire worthless.
These options bring visibility to their balance sheet, they now have control over their financial forecasts. They know they will not pay more than $90 for an oil barrel in 6 months. This certainty is given by the call options and they are happy to pay a premium to lock the price in. The premium will be lost should the oil barrel trade below $90. But to them, it is similar to buying an insurance policy.
Options have originally been created for this purpose, to hedge uncertain future events and to ensure one knows the largest possible loss s/he will take: the premium s/he paid to buy the options.
As a result, a large part of the options market involves investment banks willing to take risks and sell options (capped gain with unlimited potential loss) and corporations trying to reduce risks and buy options (capped loss with unlimited potential gain). These are generally private over-the-counter deals (not listed), tailored by the banks’ structurers to match their clients’ needs.
Along the way, people started using options to speculate rather than hedge . This is due to a particular characteristic of options: leverage. Having more leverage means that with the same amount of investment capital, you are able to multiply the amount of gain but also the amount of loss.
Going back to our Microsoft trading example, we had two scenarios, one trading the stock and the other one trading the option on the stock. Let’s first focus on the winning scenario where the share price trades at $40 in three weeks time. Trading the stock, we would buy one share at $36 today and resell it at $40 for a $4 profit. Trading the option, we would buy a call for $1.50 and make a profit of $2.50 three weeks later.
The option leverage assumes that if you had $36 in cash, you could spend it on purchasing several options instead of spending it on only one share. $36 buys you 24 call options at $1.50 each. If the stock reaches $40 after three weeks, you would make 24 x $2.50 = $60 profit. If the stock stays below your strike price of $36, you would lose all your premiums ($36).
So here is the catch, extra leverage means extra risk, larger potential profit but also larger potential losses. With an investment capital of $36, we could either make a profit of $4 (stock trading) or $60 (options trading), applying a leverage of 15 to our gain. Or we could have lost everything (options trading) instead of being able to hold on to the stock, waiting for it to bounce back in the future (stock trading).
The leverage given by options is what appeals to amateur traders. They get drawn in because they usually have a small investment capital to start with, hoping to multiply it exponentially as quickly as possible. Most of them will get burned out and lose everything for different reasons. The main ones I usually see are the following:
- Lack of understanding on how to trade options. The finite life of the option means that you cannot hold on to it and wait for a better future time if you are in a losing position.
- Too much leverage and risk taken. The lure of leverage means that some traders are treating options like lottery tickets. They are willing to take the risk of losing the premium if they can multiply their gains by 10 or 15.
The risk with being highly leveraged is that it would only take a few bad trades to completely wipe out all your investment capital, even if you have made profits for years. So before you start trading options, make sure you have a clear understanding of what you are getting yourself into!