Let’s take a closer look at the difference between trading and investing through stocks and options.
Options trading can be like a small chess game. Unlike stocks, options offer a wide range of trading techniques on the market. When investing in stocks, we essentially have only two options—speculating on a price decrease or increase. You profit when the stock price moves in the direction you speculate, down if you are shorting the stock, or up if you are long. Options, on the other hand, give us the ability to profit regardless of the stock or underlying asset’s price movement, as options don’t necessarily have to be tied to stocks.
1. STOCKS - UP OR DOWN
When you decide to invest in stocks, you have two options. The more common one is to buy stocks, known as a long position, where you speculate on the price increasing. If you are patient, have a good selection of companies, and add to your positions during dips, you are very likely to profit in the long term. However, there are stocks like Twitter, for example, which more or less stagnated for ten years. The management was unable to ensure greater monetization of this social network, and investors holding Twitter stocks were probably not too pleased.
The second option is to speculate on a price decrease, known as short selling. This technique is used by some hedge funds, often targeting smaller companies with weak balance sheets, heavy debt due to investments, and so on. Unfortunately, there have been many cases in history where prolonged short selling by hedge funds has driven such companies to bankruptcy. In the U.S., it is possible to short more shares than physically exist, albeit only for a limited time. However, funds often exceed these “loan” periods by several months or even years, as there is no effective enforcement mechanism. These practices are illegal, but given that in the event of a company’s bankruptcy or its delisting, the funds do not have to buy back the shorted shares, they realize significant profits, making it worth the risk of fines from the regulatory SEC.
In this context, you may have heard about the case of the over-shorted company GME (GameStop), which operates a chain of game stores. A community of retail traders noticed this, bought up the available shares, held them fanatically, driving the price from a few dollars to over $500 per share, causing hedge funds billions in losses and even leading to the collapse of Melvin Capital.
As individual investors, you won’t have the same influence as hedge funds, but particularly during larger market corrections or bear markets, short selling can be successful. These positions require a higher degree of active monitoring than long positions, because if the price of the underlying asset rises - going against your position - you expose yourself to “unlimited” losses.
Akcie vám dávají možnost spekulovat pouze na jejich růst nebo pokles
Abyste držením akcií vydělali, musíte dobře vybrat tituly, které mají ve vašem investičním horizontu předpoklad růstu nebo propadu. I zde existuje vícero strategií od specializace na růstové tituly, hodnotové nebo dividendové atd. Záleží na každém, jakou míru rizika a zhodnocení chce dosáhnout.
2. HISTORY of OPTIONS
Options, as we trade them today, have a relatively short history. The first options were speculated on the price of olives and grain in ancient Greece and Rome, but the modern options exchange was only established in 1973 in Chicago. At its inception, it was possible to buy options on only a few companies, some of which no longer exist, and options could only be bought, not sold or “written.” Today, approximately 40 million contracts are traded daily.
3. WHAT ARE OPTIONS USED FOR?
The primary purpose of options is to secure the ability to buy or sell at a predetermined price on a specific date. For example, if we hold stocks, purchasing a put option allows us to protect against losses in case the stock price drops. If we hold 100 shares of AAPL at an average purchase price of $100 and buy a put option with a strike price of $98 and an expiration of 90 days, we have the right to sell the shares at $98 anytime before the expiration. Why secure below our purchase price? Because buying the option isn’t free, it indirectly raises our average cost and limits profit if the price rises. It’s all about balancing the risk of loss we’re willing to accept with the minimal impact on potential profit. Higher protection equals a higher cost for the option.
Conversely, buying a call option gives us the right to purchase shares at the strike price of our call option until expiration, even if the stock price skyrockets. This type of contract can be useful for corn, wheat, or steel processors to lock in prices.
Up to this point, the understanding and purpose of options are clear. Now comes the possibility of selling, or “writing,” both call and put options, or combining the purchase and sale of options with different strikes. You can even buy a call option on one side, sell a put option on the other, and vice versa, achieving a wide range of trading strategies for various market conditions. Some strategies have names like Butterfly, Iron Condor, Strangle, Straddle, Jade Lizard, and more. You can also create your own combinations of stocks and options with different expirations and strikes. Options simply offer advanced and more flexible trading techniques in the stock market.
One option represents 100 shares at a fraction of their cost.
4. OPTIONS Specifics
One options contract represents 100 shares. If we want to hedge, for example, 200 Tesla shares, we would need to purchase two Put options. Each option has weekly or monthly expirations, and some assets, like the SPX index, even have daily expirations. Each option is tied to a specific price of the underlying asset, known as the Strike. The price of an option consists of intrinsic and time value. The time value is a very important factor. As the expiration date approaches, the time value decreases, and its decay accelerates, especially in the last 30 days.
Unlike stocks, options also offer varying degrees of leverage, which is related to the distance of the strike from the current price. This is expressed by one of the Greeks, Delta, which essentially tells us how much the value of our option will change when the underlying asset moves by one dollar. For example, a Delta of 30 means that the option price will change by $30 when the stock moves by $1. The Delta of our option will also change as the stock price moves since it is related to the distance of the option’s strike from the current stock price. Additionally, the price of the option is influenced by volatility, but that would take us into more complex combinations.
5. OPTIONS Selling
The last topic we’ll discuss today is option writing. Option writing is most commonly done on the put side of the option chains, below the current stock price. By doing this, we are indicating that we are willing to purchase shares at a lower price than the current one, and importantly, we get paid for our readiness and willingness. Now, two scenarios can unfold:
1. First Scenario: The stock price does not close below the strike price of our option on the expiration date. In this case, the situation under which we were willing to purchase the shares did not occur, and we get to keep the entire premium for our readiness to buy the shares at the strike price of the written option.
2. Second Scenario: The stock price closes below the strike price of our option on the expiration date. In this case, we automatically acquire 100 shares per written option contract at the strike price of the option. However, it’s important to note that the premium we received also remains with us, which effectively reduces the cost of the acquired shares.
Both of the scenarios described above have several sub-variants. For example, in the first scenario, we don’t have to hold the option until its expiration. If we’re satisfied with the profit, we can buy back the option for a lower premium than what we received when we sold it. In the second scenario, we don’t necessarily have to accept the shares if we roll the option to a later expiration date, usually for an even higher premium. On the other hand, we must consider that when writing options, we can be required by the counterparty to fulfill the option’s conditions at any time. This happens automatically, with the broker randomly selecting from all matching option contracts like ours. The right to exercise the option lies solely with the buyer of the option contract, not with the option writer (seller).
Options can generate profits even when the price moves against you
This phrase highlights one of the key advantages of trading options: the ability to earn money through various strategies, even if the underlying asset’s price doesn’t move in the anticipated direction.
If I mentioned at the beginning of the article that options can generate profits regardless of the stock’s price movement, we’ve just described that situation in scenario 1. By writing options, you can earn money even if you don’t correctly predict the stock’s direction. You don’t need to worry about the stock’s price movement until it starts approaching the strike price of your written option. That’s when it’s time to pay attention and potentially manage the position.
Commenti