Ben Waters, trader, manages both his own asset portfolio and outside capital, having amassed extensive experience in equity, delta one and options trading. This article will take a closer look at options trading, a complex and risky, yet potentially rewarding, activity.
For anyone diving into the options market, understanding how these financial instruments work is crucial. As Benjamin Waters, trader, is well aware, the value of options is derived from the underlying asset, which is typically a stock. The price, known as the ‘premium’, is influenced by a range of different factors, key among them the current share price (‘intrinsic value’) and the time left until expiry of the option (‘time value’).
In terms of pricing options, two primary models have emerged: the binomial and Black-Scholes models. While these mathematical formulae may appear intimidating, their purpose is simple: to enable traders to accurately determine a fair market value for options contracts. By gaining a basic understanding of binomial and Black-Scholes models, traders learn the fundamentals of options pricing, enabling them to manage risk more effectively and uncover more profitable prospects in the options market.
The value of options is attached to the underlying asset, which is usually a stock or index fund. Purchasing or selling an option comes with a price attached, known as the premium, which the purchaser pays to the seller.
There are two types of options:
- Call options, which give the buyer the right to purchase an asset at a preset price, known as the ‘strike price’, and oblige the seller to sell the asset at a strike price
- Put options, which give the buyer the right to sell an asset at a strike price, and oblige the seller to buy the asset at a strike price
Investors purchase options with the overall goal of profiting from stock price movements without owning the stock outright. Purchasing options is a common strategy among investors keen to hedge existing positions. The seller of the option receives the premium as income but takes on the risk of potential obligations.
If, for example, an individual purchases a call option on ABC stock at a strike price of $100, they have the right to purchase ABC shares at $100 each, even if the market price exceeds that sum prior to the option’s expiration.
When used to hedge other positions, options essentially serve as a form of insurance policy. Just as consumers pay a premium to insure their home or car, options buyers pay a premium to gain the right to purchase or sell a stock at a particular price. The critical factor is whether this right is worth the cost.
Options pricing models translate complex market dynamics into actionable information. Nevertheless, it is crucial to remember that such models are merely prediction algorithms. Although they provide estimates based on the present information, the market is full of surprises that these algorithms do not always account for. Factors that determine an option’s value include its intrinsic value and its time value. In addition, pricing models will also account for interest rates, prevailing market volatility and cash dividends paid, if applicable.
Successful options trading depends on the answers to three questions: which way will the stock price move, how far will it move and when will that occur? Options trading is a complex business, but it is not impossible to learn. These complex financial instruments give investors the potential for sizeable profits, but they can also lead to significant losses.
To get started with options trading, investors simply need to open an account, choose to buy or sell puts or calls, and select an appropriate strike price and timeframe. Options trading presents a unique way to profit from stock swings but nonetheless requires diligent risk management to avoid incurring heavy losses.
