Understanding options

In finance, options are used for both speculation and hedging. Today, many retail investment platforms online offer options trading, which means that this type of instrument is no longer out of reach for the average small-scale hobby trader.

Affordability

One of the reasons investors like options are because they can be very affordable. Instead of buying an asset (such as company shares) outright, you get exposure to its price movements through options which require a much smaller investment.

Options are within reach even for traders with a small bankroll. Among traders with larger bankrolls, options trading is still popular because they mean putting less of your total bankroll on the line. Many traders stick to rules about never putting more than a certain fraction of their total bankroll into one single trade, and they also do not want more than a certain percentage of their total bankroll to be in open positions at any given time. By using options instead of buying an asset, they gain exposure without violating their risk-management rules.

Example:

1.) The share price for common stock in Company BCDE is currently $450. You think that the price will go up soon, and would like to gain exposure to 100 shares. Buying them outright would cost $450 x 100 = $45,000. Your total bankroll is $50,000 so putting $45,000 into this trade would pretty much be a case of ”putting all your eggs in one basket”.  

1. Instead of buying the shares, you decide to buy a 100 shares Stock Option that will yield you a profit if BCDE´s share price goes up. This costs much less than actually buying the shares, so you are putting much less of your total bankroll on the line.
2. On the option´s expiry date, the share price is $500. Your prediction came true. The issuer of the stock options pays you 100 shares x ($500 + $450) = $5,000. You made a substantial profit without having to put $45,000 in an open position.

Makes it easy to profit from falling prices

You have reason to believe that the share price of Company EFGH will be going down soon. So, how can you profit from this prediction? Profiting by investing in a company is only an option for prices that go up, not down.

Short-selling: The high-risk way of speculating on falling prices

One method to profit from falling prices is short-selling. In essence, you would borrow 100 shares in Company EFGH from your broker and sell them on the market for the current market price. Let´s say the market price is $90. You sell 100 shares for $90 each and get $9,000. Now, you wait for the price to go down. When it is down to $80 you decide to buy. You buy 100 shares for $80 each, and pay $8,000. You return the 100 share to your broker. The short-selling has yielded you $9,000 minus $8,000 = $1,000.

Many traders do not want to engage in short-selling since it is so risky, and the downside is virtually unlimited. What happens in the example above if your prediction turns out to be wrong and the share price actually goes up? What if the share price is $150 on the day when you have to return 100 shares to your broker? You would have to buy those shares for $150 x 100 shares = $15,000. The short-selling would set you back $15,000 minus $9,000 = $6,000. The scary thing is, that in theory, the share price can skyrocket. If you invest $10,000 in a company, you can not lose more than $10,000. Even in a worst case scenario where the company files for bankruptcy and the share price drops to zero, you can still not lose more than what you put in. With short-selling, there is no such limit. Let us take another look at the example above. Let´s say that Company EFGH was producing high-quality face masks and a pandemic caused a sudden surge in market demand for face masks. Short-term speculators would flock and drive the share price up up up. On the day when you had to return 100 shares to your broker, the share price might be $250 and buying 100 shares would cost $25,000. This is why short-selling is so dangerous.

Options: A safer solution since the downside is limited

So, how to go about if you think that the price of EFGH shares is going down, but you don´t want to  do short-selling? Once solutions is to buy a stock options for 100 shares of EFGH. Example: The current market price is $90 per share. You buy an option that allows you to sell 100 shares for $90 on the expiry date.

Scenario A: On the expiry date, the share price is $80. You execute (use) the option, and the issuer pays you ($90 – $80) x 100 shares = $1,000.

Scenario B: On the expiry date, the share price is $150. You simply decide to not execute (use) the option. You allow the option to expire, and you only lose the money it cost you to buy the option. This is a fixed sum that you knew in advance that you might loose. You knew when you invested exactly how much you could lose, so there are no surprises for your bankroll.

It is not surprising that so many traders prefer options to short-selling, especially traders who are risking their own money and aren´t back by big financial institutions.