Find out what are the benefits and risks of trading Stock Options with Saxo Capital Markets.
What are the benefits of trading Stock Options?
Although options may not be appropriate for everyone, they’re among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling, and neutral markets.
Minimising the risk
For many investors, options are useful as risk management tools that help to protect your portfolio against a drop in stock prices.
For example, if Investor A is concerned that the price of his shares in XYZ Corporation is about to drop, he can purchase puts that give him the right to sell his stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, Investor A has protected himself against losses below the strike price.
This type of option practice is also known as hedging. While hedging with options may help you manage risk, it’s important to remember that all investments carry some risk, and returns are never guaranteed.
Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price for them. They can also profit from a rise in the value of the option’s premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.
Reducing the cost
Options allow holders to benefit from movements in a stock’s price at a fraction of the cost of owning that stock. For example: Investors A and B think that stock in company XYZ, which is currently trading at $100, will rise in the next few months. Investor A spends $10,000 on the purchase of 100 shares. But Investor B doesn’t have much money to invest. Instead of buying 100 shares of stock, he purchases one XYZ call option at a strike price of $115. The premium for the option is $2 a share, or $200 a contract, since each contract covers 100 shares. If the price of XYZ shares rises to $120, the value of his option might rise to $5 or higher, and Investor B can sell it for $500, making a $300 profit or a 150% return on his investment. Investor A, who bought 100 XYZ shares at $100, could make $2,000, but only realise a 20% return on her investment.
Investors can protect long term unrealised gains in a stock by purchasing puts that give them the right to sell it at a price that’s acceptable to them on or before a particular date. For the cost of the premium, a minimum profit can be locked in. If the stock price rises, the option will expire worthless, but the cost of the premium may be offset by gains to the value of the stock.
Investors who anticipate a market upturn can purchase calls on stock to participate in gains in that stock’s price—at a fraction of the cost of owning that stock. Long calls can also be used to lock in a purchase price for a particular stock during a bull market, without taking on the risk of price decline that comes with stock ownership.
Investors with an aggressive outlook use options to leverage a position in the market when they believe they know the future direction of a stock. Options holders and writers can speculate on market movement without committing large amounts of capital. Since options offer leverage to investors, it’s possible to achieve a greater percentage return on a given rise or fall than one could through stock ownership. But this strategy can be a risky one, since losses may be larger, and since it is possible to lose the entire amount invested.
Conservative investors can use options to hedge their portfolios, or provide some protection against possible drops in value. Options writing can also be used as a conservative strategy to bolster income. For example, say you would like to own 100 shares of XYZ Corporation now trading at $56, and are willing to pay $50 a share. You write an XYZ 50 put, and pocket the premium. If prices fall and the option is exercised, you’ll buy the shares at $50 each. If prices rise, your option will expire unexercised. If you still decide to buy XYZ shares, the higher cost will be offset by the premium you received.
Even those investors who use options in speculative strategies, such as writing uncovered calls, don’t usually realise dramatic returns. The potential profit is limited to the premium received for the contract, and the potential loss is often unlimited. While leverage means the percentage returns can be significant, here, too, the amount of cash changing hands is smaller than with equivalent stock transactions.
What are the risks of trading Stock Options?
While options can act as safety nets, they’re not risk free. Since transactions usually open and close in the short term, gains can be realised very quickly. This means that losses can mount quickly as well. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.
Risking your principal
Like other securities—including stocks, bonds, and mutual funds—options carry no guarantees, and you must be aware that it’s possible to lose all of the principal you invest, and sometimes more. As an options holder, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise. However, since initial options investments usually require less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you’d bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage: Percentage returns are often high, but it’s important to remember that percentage losses can be high as well.
NOTE: Understanding Premium - The value of an equity option is composed of two separate factors. The first, intrinsic value, is equal to the amount that the option is in-the-money. Contracts that are at-the-money or out-of-the-money have no intrinsic value. So if you exercised an at-the-money option you wouldn’t make money, and you’d lose money if you exercised an out-of-the-money option. Neither would be worth the cost of exercise transaction fees. But all unexercised contracts still have time value, which is the perceived—and often changing—currency value of the time left until expiration. The longer the time until expiration, the higher the time value, since there is a greater chance that the underlying stock price will move and the option will become in-the-money.
One risk in particular is options are very time sensitive. The value of an option diminishes as the expiration date approaches. For this reason, options are considered wasting assets which means they have no value after a certain date. Stockholders, even if they experience a dramatic loss of value on paper, can hold onto their shares over the long term. As long as the company exists, there is the potential for shares to regain value. Time is a luxury for stockholders, but a liability for options holders. If the underlying stock or index moves in an unanticipated direction, there is a limited amount of time in which it can correct itself. Once the option expires out-of-the-money it is worthless, and you, as the holder, will have lost the entire premium you paid. Options writers take advantage of this, and usually intend for the contracts they write to expire unexercised and out-of-the-money.
NOTE: Owning options - It’s also important for you as an options investor to understand the difference between owning options and owning stock. Shares of stock are pieces of a company, independent of what their price is now or the price you paid for them. Options are the right to acquire or sell shares of stock at a given price and time. Options holders own the rights to what’s sometimes described as price movement, but not a piece of the company. Shareholders can benefit in ways other than price movement, including the distribution of dividends. They also have the right to vote on issues relating to the management of the company. Options holders don’t have those benefits and rights.
Since options are wasting assets, losses and gains occur in short periods. If you followed a buy and hold strategy, as you might with stocks, you’d risk missing the expiration date or an unexpected event. It’s also important to fully understand all potential outcomes of a strategy before you open a position. And once you do, you’ll want to be sure to stay on top of changes in your contracts.
- Since an option’s premium may change rapidly as expiration nears, you should frequently evaluate the status of your contracts, and determine whether it makes financial sense to close out a position.
- You should be aware of any pending corporate actions, such as splits and mergers, that might prompt contract adjustments. Check OIC’s website, www.OptionsEducation.org, for changes.