Options: Essential Basics Not To Be Missed About Options Trading

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What Are Options?

An option is a financial derivative tool that allows the holder to choose whether to buy or sell an underlying asset at a predetermined price in the future, without the obligation to exercise the option. In simpler terms, an option is like a contract that gives an investor the right to buy or sell an asset without the need to act immediately. However, to have this right, the investor must pay a fee known as the premium.

What makes options special is that they not only help investors protect their portfolios but can also profit from the price fluctuations of the underlying asset without owning the asset directly. Therefore, options have become a key tool in the investment strategies of professional investors.

Basic Information About Options

Types of Options

There are two basic types of options in trading: Call Option and Put Option. Each type serves different purposes and uses:

1. Call Option: This gives the holder the right to buy the underlying asset at a set price in the future. Investors buy this option when they expect the asset price to rise.

2. Put Option: This gives the holder the right to sell the underlying asset at a set price in the future. Investors buy this option when they expect the asset price to fall.

Strike Price

The strike price is the price at which the option holder can buy or sell the underlying asset. This is an important factor in determining whether the option will be profitable for the investor. If the market price of the underlying asset is higher than the strike price of a call option, the investor can exercise the option and make a profit. Conversely, if the market price of the underlying asset is lower than the strike price of a put option, the holder of the put option can sell the asset at a higher price.

Expiration Date

The expiration date is the period during which the option is valid. Once the expiration date has passed, the option expires and loses its value. This means that if the option is not exercised before the expiration, the investor will lose the entire premium paid for the option.

Exercising an Option

Steps to Exercise an Option

1. Buy the Option: The investor pays a premium to obtain the right to buy or sell the underlying asset in the future.
2. Hold the Option: During the validity period, the investor can choose to hold the option and wait for market fluctuations.
3. Exercise the Option: If the price of the underlying asset moves favorably, the investor can exercise the option and make a profit. Otherwise, they may choose not to exercise the option and lose the premium paid.

Settlement of Options

When exercising an option, there are two common forms of settlement:

1. Physical Settlement: When the option is exercised, the underlying asset is physically transferred between the two parties. This is commonly seen with options related to stocks or commodities.

2. Cash Settlement: Instead of transferring the underlying asset, the investor receives a cash payment based on the difference between the strike price and the market price of the underlying asset at the time of exercise. This form is typically used for options related to stock indices or other financial assets.

Example of an Option

For example, suppose you buy a call option on XYZ stock with a strike price of 50 USD and an expiration of 1 month. The premium you pay is 2 USD. If, within a month, the price of XYZ stock rises to 60 USD, you can exercise the option and buy the stock at 50 USD (even though the market price is 60 USD). You can then sell the stock at the market price and make a profit of 10 USD (60 – 50) minus the 2 USD premium, resulting in a net profit of 8 USD per share.

However, if the price of XYZ stock does not exceed 50 USD, the option expires worthless, and you only lose the premium paid, which is 2 USD.

Options can yield high returns but also carry significant risk. Therefore, investors need to understand the basic elements before engaging in options trading.

History and Development of Options

Options originated in the 17th century in the Netherlands, where investors began using options to hedge commodity transactions. However, the significant development of options only truly began in the late 20th century, when CBOE (Chicago Board Options Exchange) was established in 1973, creating the first legitimate options trading market. This marked the beginning of a new era for options in financial markets.

Before the establishment of CBOE, options were mostly traded through private contracts, with no official regulation or oversight. With the advent of CBOE, clear regulations, trading systems, and standards for options were established. This not only helped options become widely accepted financial instruments but also laid a strong foundation for the development of other derivative financial instruments.

Common Options Trading Strategies

When trading options, investors can use various strategies to optimize profits and minimize risk. Here are some popular strategies in options trading:

1. Covered Calls: This strategy involves selling a call option on the stocks an investor owns. The goal is to generate extra income from the premium of the sold option. This strategy is suitable when the investor believes the stock price will not increase significantly.

2. Protective Puts: This involves buying a put option to protect a stock position from price declines. By using this strategy, the investor pays a premium to retain the right to sell the stock at a set strike price, providing protection against price drops.

3. Straddle: This strategy involves buying both a call option and a put option of the same type, strike price, and expiration date. Investors use this strategy when they anticipate strong price fluctuations in the underlying asset but are uncertain about the direction.

4. Strangle: Similar to a straddle, but with different strike prices for the call and put options. This strategy helps reduce the premium paid but requires greater price movement in the underlying asset to be profitable.

5. Butterfly: This strategy involves buying and selling options with different strike prices but the same expiration date. Butterfly is suitable when the investor believes the asset’s price will remain relatively stable within the time frame of the option’s validity.

6. Iron Condor: A combination of the Strangle and Butterfly strategies, where the investor sells a call option and a put option with nearby strike prices and buys additional options with higher and lower strike prices to reduce risk. This strategy is suitable for investors expecting the market to remain stable.

Risks and Risk Management in Options Trading

Although options are a flexible financial tool with the potential for high returns, options trading also involves many risks, especially for inexperienced investors. Below are the main risks involved in options trading and how to manage them:

1. Risk of Losing the Entire Premium: When buying options, investors must pay a premium. If the option is not exercised (because the underlying asset does not move as predicted), they will lose the entire premium. To manage this risk, investors need to set a reasonable level of risk tolerance and avoid over-investing in each option.

2. Liquidity Risk: Options may lack liquidity, especially for assets that are not widely traded or long-term options. This can make buying or selling options difficult. To mitigate this risk, investors should trade options on markets with high liquidity and avoid trading options during periods of low trading volume.

3. Market Risk: Market fluctuations can cause options prices to change rapidly. To manage this risk, investors can use protective strategies like Protective Puts or combine options with other assets to diversify their investment portfolio.

“Note: Investors always need to have a clear plan before engaging in options trading. Never risk more than you are willing to lose.”

Market Volatility’s Impact on Option Pricing

The value of an option is influenced not only by the price of the underlying asset but also by several other factors. Key factors include:

1. Delta (Asset Price Fluctuation): Changes in the price of the underlying asset directly impact the option price. When the underlying asset’s price moves significantly, the option price will adjust accordingly.

2. Vega (Volatility): The volatility of the underlying asset affects the option’s value. Options tend to be more valuable when the asset has high volatility, as the likelihood of significant price changes increases, creating more profit opportunities for the option holder.

3. Theta (Time Decay): Options lose value as the time to expiration decreases. This “time decay” is especially important for short-term options.

4. Rho (Interest Rates): Interest rates influence the option’s value, especially for long-term options. When interest rates change, the opportunity cost of holding the option also changes, leading to fluctuations in the option’s value.

Classifying Options Based on Liquidity and Characteristics

Options can be classified based on the liquidity and characteristics of the underlying asset:

1. High Liquidity Options: These options are linked to high-liquidity assets, such as stocks of large companies or stock indices. Trading options on these assets is usually easier, with lower transaction costs.

2. Low Liquidity Options: These options are often traded on less popular or less liquid assets, such as stocks of small companies or special commodities. Trading risks and costs can be much higher in these cases.

3. Protective Options: These are options purchased as part of a strategy to protect an investment portfolio, such as put options to hedge stocks in the portfolio.

4. Speculative Options: These options are typically purchased with the expectation that the underlying asset’s price will experience significant fluctuations in the future, allowing the investor to profit from these movements without owning the asset.

“When trading options, investors need to fully understand each type of option and the factors affecting them to develop the right strategy and optimize returns.”

Options and Taxes

Taxes are an important consideration for investors when trading options, as they can affect the net profit from these trades. In many countries, taxes on profits from options may differ from taxes on underlying assets like stocks or bonds. One of the significant factors is the holding period of the option before exercise, as tax regulations may distinguish between short-term and long-term profits.

1. Short-Term Profit: If an option is bought and sold within a year, the profit from the trade is taxed as short-term income, usually subject to a higher tax rate than long-term income. This can reduce the investor’s return if there is no proper strategy in place.

2. Long-Term Profit: If an investor holds an option for a long period (typically over one year), they may benefit from a lower tax rate on the profit from the option, similar to other long-term investments.

To optimize taxes, investors can consider strategies to hold options longer to benefit from lower tax rates or combine options trading with other tools like tax-loss harvesting to reduce taxes owed.

Using Options in Portfolio Management

Options are not just speculative tools but also powerful instruments in portfolio management. Investors use options to hedge risks or generate additional income from their portfolios.

1. Hedging: Investors can use options to protect their portfolios from unfavorable market fluctuations. For example, an investor holding stock in a company but fearing a short-term decline in the stock price can buy a put option to hedge against the risk of losing value. This limits potential losses while still retaining the benefits of long-term asset growth.

2. Income Generation: Strategies like Covered Calls allow investors to earn additional income from the premium of sold options while retaining stocks in their portfolios. This strategy is suitable for stable stocks with little price fluctuation, where the investor does not expect significant growth in the short term.

“Note: When using options in portfolio management, investors must have a clear plan and not rely on them solely as speculative tools.”

The Difference Between Options and Other Derivatives

Options are one of many financial derivative tools, but they differ from other derivatives like futures, swaps, and CFDs in terms of operation and risk level.

1. Futures: Unlike options, futures contracts require both parties to fulfill the trade at a specified time in the future, with no option to decline. This creates a significant difference in risk, as the investor cannot choose not to fulfill the contract, as with options.

2. Swaps: A swap is an agreement between two parties to exchange cash flows over a set period. While options allow investors to participate in the price fluctuations of assets without owning them, swaps are primarily used to manage interest rate or currency exchange risks.

3. CFDs (Contracts for Difference): CFDs allow investors to trade the price changes of assets without owning them. However, unlike options, CFDs do not have a “choice,” meaning the investor has no option to decline the trade if the market moves against their prediction.

Options are much more flexible than other derivatives due to their characteristic of providing “rights” rather than “obligations” to execute trades.

Technical Analysis Tools for Options

Technical analysis is an important tool for predicting the value of options and the price trends of underlying assets. Common technical indicators in options trading include:

1. Bollinger Bands: Bollinger Bands help investors identify extreme price levels of the underlying asset, enabling decisions to buy or sell options based on price changes.

2. Moving Averages: Moving averages help determine the trend of the underlying asset over a specified period, assisting investors in making reasonable decisions about whether to buy or sell options.

3. RSI (Relative Strength Index): RSI measures the overbought or oversold levels of the underlying asset, helping investors determine when to buy call options or sell put options.

These indicators help investors not only track the price of the underlying asset but also generate signals to optimize options trading strategies. Combining technical analysis tools will enhance the ability to accurately predict options price fluctuations.