A brief guide to options trading

Hey there, time traveller!
This article was published 07/09/2022 (1303 days ago), so information in it may no longer be current.

Dear Money Lady Readers,

Let’s talk about option trading. Have you tried it?

My son who is in his mid-20s with degrees in physics and mathematics, seems to think he can take on the stock market through options trading, so today we are going to talk about this investment strategy. Options and forwards are quite a complicated model, even though there are many investors who think they can master them. Essentially you will use a security or derivative in an existing or anticipated position and speculate on the value of the asset.

Options and forwards are both contracts between buyer and sellers in the stock market. With forwards, there is no up-front payment. Both the buyer and the seller create a contract to trade an asset in the future at a set price agreed upon at the time of the contract and both are then obligated to participate in the trade no matter what the outcome. Forward contracts are very customizable and can even be private agreements that settle with a broker or dealer who can negotiate the transaction directly with you and the other party. This is considered to be an OTC (over the counter) trade.

Most people, such as my son, gravitate to options trading instead, because it is much easier to initiate and understand, without the need of an OTC transaction. Options are also widely available, easily tradeable on most broker platforms, very liquid, and can be bought or sold with less capital requirements than forwards. There are two elements that make up an option: a call and a put. A call option gives you the rights to buy the asset and the put option gives you the right to sell.

The buyer of an option has the right to either buy or sell a stock, sometime in the future, at a strike price that is always agreed upon at the time the position is opened. The seller, on the other hand must sell or complete the transaction if the option is exercised. You may often hear the terms “long and short positions” when trading in options. The buyer is considered the long position or holder of the contract and the seller is considered the short position or writer of the contract.

If you want to be the buyer of the option, you will have to pay a fee or premium to do so, which varies in price, based on volatility and the time to expiration of the contract. Once this fee has been paid, the buyer really has no further obligation to the contract other than to decide if they want to exercise the option or not. Basically, most people choose to “gamble” with their options as buyers, since they only stand to lose the premium, paid up-front. Now, if you are the seller, or option writer, you will always be forced to buy or sell if you are assigned, and if you are “right” you get to keep the premium from the buyer, but if you are “wrong” you could potentially lose a lot. The reason for this is because the trade units are always 100 shares at a time.

The allure of option trading is quite real with many people gravitating to this platform because it can be very exciting.

Let’s look at an example together. If you have a favourite stock which you believed would go up in value over the next few weeks, you could buy a call option. If the stock does go up before the expiry date of the contract and it moves above the strike price plus the premium (this is your break-even cost) then you would be, as they say in the industry, “in-the-money,” potentially winning big because the share unit is 100, (every one dollar rise in the stock price above your break-even price will lead to a $100 profit). But, if the stock stays below the strike price, you will lose your paid premium. The opposite side of this equation is the seller or writer of the option. This would be called a short put. When selling options, you will have more risk, and will have to be a little more tactical to pivot with stock market swings. When you believe the stock will stay high in a volatile market, you can sell a put. If the stock stays above the strike price, then you keep the premium; but if it doesn’t, you could stand to lose your shirt. To reduce your risk you will need to utilize either a ‘vertical put credit spread’, ‘iron condor’, or ‘butterfly spread’ option strategy, (all of which are too detailed to discuss here).

Whatever you do, please be careful when trading in options or forwards. I have seen people get into trouble very quickly when trading in these arenas. Only use funds that are not important to your future. The minute you start to dip into your retirement savings to make up for losses, it is almost guaranteed that the environment will become lethal, and your emotions will always cloud your judgement.