The power of options lies in their versatility. They can be used to speculate on market moves or to protect a position. In this lesson, we will focus on how a speculator can make use of options.
The two types of options are Calls and Puts:
- A Call gives the holder the right but not the obligation, to buy at an agreed upon price on expiry.
- A Put gives the holder the right but not the obligation, to sell at an agreed upon price on expiry.
The agreed sell/buy price available to an option holder is called the strike rate. An option buyer will benefit if the strike rate can beat the market! If you are holding a Call option, the strike will become more attractive as the market rises, and if you are holding a Put option, the strike will become more attractive as the market falls. Here is a Put example.
Buy Put example
If company ABCD is trading for $50/share and you expect the share price to fall, but you don’t have the confidence to short (through selling) the stock because there is a possibility you could face an unlimited amount of loss if you are wrong, you can buy a Put option instead, giving you the right to sell at a specified price any time before the expiration date.
You choose to buy a Put option giving you the right to sell the stock at $40 over the next month. This option will cost you $5.
- Strike – $40
- Expiry date – 1 month from today
- Premium to pay – $5
Now, imagine the scenario in which the company’s share price does what you expect. It goes down, and before the end of one month, it has gone down to $20. Then, you decide to exercise your option, which allows you to sell the stock at $40. If you don’t own it, that’s ok because you can go and buy the stock right now on the market at $20. You are buying at $20 and selling at $40, thus you are making $20.
Then, if you subtract the premium you paid for the option you will have a $15 profit.
On the other hand, if your bet goes against you and the share price goes up, it’s not like a short (selling) position where you can lose an unlimited amount of money. The maximum risk when you buy an option is the premium paid, in this case that is $5. Even if the stock went to a trillion dollars, you are not required to buy it back like you would if you were shorting it.
Under the same reasoning, you can buy a Call option to trade a rising share price. If the price rises the Call option allows you to buy at a lower price than the market. The difference between your Call option’s strike rate and the market rate is your profit (before subtracting the premium paid for the option).
On the trading platform, options are cash-settled. This means the actual physical delivery of assets (currency or commodity) is not required. Instead, at the option’s expiry, cash is credited to your free balance in the amount of the difference between the strike price and the current market value of the asset. If an option has no value on closing the position, no cash is credited to your free balance.
A benefit of trading on an electronic platform is your real-time profit or loss from the transaction (trade) is calculated for you. Profit and loss can be monitored and trades can be closed before expiry via the open positions’ screen.
We have mentioned when buying an option you pay a premium, the ‘open premium’. Whilst you hold an option, the premium value changes depending on changes in the underlying market.
The premium of a buy Put trade increases as the market falls. Why? Because the Put’s strike rate becomes more attractive relative to the market rate.
The premium of a buy Call trade increases as the market rises. Why? Because the Call’s strike rate becomes more attractive relative to the market rate.
The difference between the ‘premium at open’ and ‘premium now’ is your running profit or loss.