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Mechanics of Stock Option Trading
Options are a form of security mainly reserved for the sophisticated investor who is able to understand its inherent risks and practical uses. Options are attractive due to their versatility and their capacity to interact with other orthodox assets, for instance, stocks. They empower an investor to adjust their position as the market shifts. For example, options are an effective hedging tool to safeguard against a subdued stock market hence minimizing losses. Additionally, options can either be used for speculative purposes or as a conservative investment. Option trading forms part of an investment strategy (Hayes, 2017).
The trading of options and the negotiations of the terms of the contract happen in an over-the-counter (OTC) market. The OTC market is advantageous over the exchanges because it allows for the tailor-making of a contract—that is a negotiated expiration date, strike price, and the underlying number of shares. Nonetheless, the versatility brings with it greater cost and reduced liquidity. The onset of options trading was in 1973 when the Chicago Board Options Exchange was organized to take part in the trade of standardized contracts. The CBOE was the first exchange, but by the beginning of the 21st century the electronic International Securities Exchange, which is New York based, superseded its liquidity and trade volume. Other option exchanges include the NASDAQtrader and the NYSE Euronext (Gillies, 2017).
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The functional versatility of options is associated with some costs. If they are applied improperly, then they can increase an investor’s risk: due to their complexity. Options are classified under the larger group known as derivatives. Options derive their value from other financial securities. The value of an option is intrinsically linked to the price of an underlying asset. To be more specific, options are contracts that afford a right, but not an obligation to trade on some other asset at a specified price either before or on a specific date. Options are traded in similar form as stocks. A buyer asks for a price and the seller bids a price. Settlement for option trades is set at one business day, that is T+1. Traders wishing to participate in the market must open a brokerage account, seek for approval to trade in options and must receive a booklet titled Characteristics and Risks of Standardized Options.
Unlike stockholders, option holders do not have voting rights nor do they qualify to receive dividends, Moreover, the brokerage fees for option trades are a bit higher than stock trades, and are applicable when both selling and buying options and when an investor seeks to exercise or assign option contracts. The brokerage fees are quoted with two components, that is the base price and the per contract charge. The base price ranges from a minimum of $5 to $15 for up to ten contracts. A per contract charge of between $0.50 and $1.50 is levied for more than ten contracts. Active traders usually receive lower brokerage fees (Gillies, 2017).
Puts and Calls
A put option and a call option is the right to sell and buy respectively. A call option might be considered as a deposit that would be called upon in the future, whereas the put option can be considered as an insurance policy. Investors use call options for three purposes: speculation, generation of income and management of tax (Graham, 2017). Call options put an investor in a long market position; therefore, the seller of the option takes a short position in the market. When an investor owns an option, they are in a short position, but if they are selling the option, then they are in a long position. This defines the four things an investor can do with an option: sell puts, buy puts, sell calls and buy calls.
To elaborate, individuals that buy options are referred to as holders and investors that sell them are known as writers. A distinction between buyers and sellers is that buyers—put and call holders—are not required to buy or sell and can exercise that right if they choose. It limits their risk to the premium of the option only. The sellers—put and call writers—are on the other hand obligated to sell. Sellers must make good their promise to buy or sell and this delimits their risk. Writers, therefore, lose much more than the option’s premium.
Stock Trading Strategies
There are a variety of option trading strategies each with its characteristics. Each strategy is a unique combination of underlying assets, derivatives and a combination of options. Option strategies offer a combination of concurrent selling and buying where traders profit from the shift in the price of the underlying asset depending on whether they are neutral, bullish or bearish. These strategies include option spreads, ratio spreads, covered call, protective put, collar, to name but a few.
Protective puts are bought for protection and minimizing loss of stocks already owned. A covered call is the writing up of a call for stock in possession. For more complicated strategies that combine these two is the collar. The collar is the application of a covered call and protective put to apprehend the value of an option within two bounds. The lower bound is protected by the protective put and the call covers the upper bound. The call is sold at the strike price which is then used to purchase the protective put. Collars are used by traders to increase their profit margins as well as limit their downside. An option spread is a strategy that applies selling and buying of multiple combinations of calls and puts with varying strike prices. Option spreads are classified into money spreads (vertical), time spreads (horizontal) and diagonal spreads depending on the expiration dates and strike prices. Diagonal spreads have different strike prices and expiration dates; the time spreads have same strike prices but different expiration dates; the vertical spreads have different strike prices but the same expiration dates.
Investor Using Stock Option Trading
Let’s take for instance a trader that applies the collar option trading strategy. A trader owns 1000 shares of Coca-Cola at a current price of $46.10 (Google Finance, 2017) and wants to keep ownership of them until next year so that they can defer tax payment on their profit but only pay the capital gains tax. The trader purchases ten protective puts with a strike price of $45 with a January 2018 expiration date. Also, they sell ten calls at the strike price of $50 with a similar expiration date. Therefore, the trader gets $550 for the covered call and pays $450 for the puts—netting $100. If the KO share rises to $50, then the trader pockets $50,000. But if the share drops to say $40, then the share would be worth $40,000 and the puts $5,000. A further drop in price increases the value of the puts that is directly proportional to drop in share price. Consequently, maximum payout for the share would be $50,000 and the least would be $40,000. Considering $100 was already earned then the trader’s position would be collared at $40,100 lower bound and $50,000 upper bound.
- Gillies, J. (2017). Options: The Basics. The Motley Fool.
- Google Finance. (2017). The Coca-Cola Co: NYSE: KO quotes & news. Finance.google.com.
- Graham, J. (2017). Getting Acquainted with Options Trading. Investopedia.
- Hayes, A. (2017). Options Basics Tutorial. Investopedia.