If you’re new to trading the markets, then you may have come across the term ‘Options Trading’ and wondered what it’s all about. If you are just looking for a simple explanation to get you started, then you are in exactly the right place.
Most articles on Options are very confusing, often using jargon terminology such as ‘Calls’, ‘Puts’ or ‘Premium’ early in the explanation, which scare many from researching the topic any further.
Options are undoubtedly a more complex form of trading, much more suited to those with greater knowledge and experience. However, if used appropriately, will enable you to develop far more sophisticated trading strategies.
What are Options?
As a simple definition, an option trade is ‘the Option to Buy (or Sell) a product at a later date’.
You may have experienced a type of Options trading when buying items such as a car, a house or even a sofa. Often you can pay a deposit to secure the item. This means that you then have a choice. You can either continue to purchase the item at a later date, or you can back-out. If you back-out then you would probably lose your deposit. This ‘choice’ to buy or not at a later date is the ‘option’. i.e. you have the ‘option’ to buy at a later date or not.
The term ‘Option’ is very important, as it indicates the holder has the option, but not the obligation to Buy (or Sell) the product. This makes it different from a ‘Future’, where there is an obligation to Buy (or Sell), rather than having a choice whether to or not.
Why Trade Options?
At this point it is useful to have a good understanding of what Futures are, before continuing with this article.
A Future commits you to buying or selling a product at an agreed price in the future. This is very useful if you are sure the price will move in your favour before the agreed future date arrives. However if it has moved a long way against you, then you may incur big losses.
This makes Options very useful when there is much greater uncertainty in the future. As when the agreed future date arrives, if the price movement has not been in your favour, then you can choose not to Buy (or Sell), and perhaps only incur a small loss.
Options Example without the Jargon!
Its currently September and you check the stock price of Apple (AAPL) and see it’s trading at $148.50 per share.
You hear that Apple are going to release a new iPhone in October, and you think that this new phone will do very well and send Apple’s price much higher. However, you are also worried that it may be a failure and send the stock price tumbling.
You thought about buying a Future, but are concerned that if you did, and the new phone was a failure, then it would send the stock price tumbling, and cause you significant losses.
You therefore choose to investigate what it would cost for an option to Buy Apple Stock at $180 a share in December after the Black Friday and Christmas sales. The Broker quotes you $0.60 a share.
You think this is a good trade and agree to buy 100 Options. This costs you $60 (100 shares x $0.60)
Scenario 1 – come December, Apple has done very well and the share price rockets to $200 a share. You commit (called exercising) the option and you pay $18,000 for your 100 shares (100 shares x $180). You paid a total of $18,000 + $60 = $18,060 for your 100 Apple shares, but they are now worth $20,000 (100 shares x $200). A profit of $1,940
Scenario 2 – in December Apple has done badly and the share price has dropped to $120 a share. You decide not to take up the option to buy the shares. Your only losses are the $60 you paid to buy the option.
Why not just Trade Options and not Futures?
From the description and examples given, it seems that it would make much more sense for traders to just buy Options and not Futures, as with Options you can choose not to continue with the deal if the price moves against you.
Although this is true, as with most things in life, there is a cost element to consider. In the case of options it is the amount it costs you to actually purchase the option in the first place.
The actual cost of buying the option often means that the price must move further in your favour before you are in profit. A small price movement in your favour may cause you to make money buying a Future, but may still cause you a loss when buying an option.
Common Options Terminology
These are terms you will frequently encounter with Options trading, we highly recommend familiarising yourself with them. There are many more complicated terms that we cover in part 2 on Options Trading.
The simplest type of Option, and the one we have used for all the explanations so far is the Call Option. This is the choice to Buy a product at a set price at an agreed future date. E.g the option to Buy Apple Stock at $200 a share.
In addition to the Option to Buy, there is also the Option to Sell, referred to as a Put Option. This is defined as the choice to Sell a product at a set price at an agreed future date. E.g. the option to Sell Apple Stock at $200 a share.
The term ‘Strike’ refers to the very significant price level that the Option refers to. If you buy a Call Option on Apple at $200 then the ‘Strike’ price refers to the $200 price that the stock can be bought for with the Option.
You may have also heard of the term ‘Premium’. This is the name given to the price paid for having the option itself. In our above example for Apple shares, the cost to buy the option (not the cost for the shares themselves) is known as the premium.
Selling as well as Buying Options
When Options Trading, you don’t just have the possibility of being the buyer of an Option. You could also be the seller of the Option.
However, this is where Options trading begins to become a little more complicated. Selling Options can take a little while for people to really get their head around what price levels they make and lose money.
If you Buy a Call Option, then the person who sold it to you must be the Seller of the Call Option. Likewise, if you Buy a Put Option, the person who sold it to you is the Seller of a Put Option.
This then provides the following 4 possibilities to traders, along with the desired effect on price:
Buy a Call Option – you want prices to rise or stay above a above a set price
Sell a Call Option – you want prices to fall or stay below a set price
Buy a Put Option – you want prices to fall or stay below a set price
Sell a Put Option – you want prices to rise or stay above a above a set price
Most importantly, selling options can be very risky and should be treated with great caution. Selling an Option has limited profitability and often unlimited downside. Advanced traders rarely Sell Options without also holding another simultaneous trade to limit their losses.
See our article Top 10 Beginner Trading Mistakes to get a better idea of simple mistakes you could easily avoid!
If you want to know even more about Options Trading
If you can imagine placing multiple trades on a single product, simultaneously buying and selling Call and Put Options, as well as trading the Futures and underlying market, then you can quickly create a complex situation.
Although complex, it also provides the ability to create very sophisticated trading positions from which advanced traders can create into very profitable situations.
This has been a very simple ‘quick’ guide to Options trading. A further article offering more detail will be published shortly. This will provide details of more complex elements to help further your journey!
