SAFE OPTIONS TRADING MYTH OR FUTURE

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Is it Risky to Invest in Options?

In the world of investing, there are a lot of securities in which you can invest your money: stocks, bonds, commodities, mutual funds, futures, options, and more. Most investors stick with mutual funds. Of course, there is a fee, but it takes all the management worries away. Many will invest in stocks and bonds to try to capture larger gains. And some will invest in options. Options trading can be an excellent way to increase your net worth if you do it right.

Key Takeaways

  • An options contract is an arrangement between two parties that grant rights to buy or sell an asset at a particular time in the future for a particular price.
  • The intended reason that companies or investors use options contracts is as a hedge to offset or reduce their risk exposures and limit themselves from fluctuations in price.
  • Because options traders can also use options to speculate on price, or to sell insurance to hedgers, they can be risky if used in those ways.

What are Options?

Options are contracts that give you the right, but not the obligation, to buy or sell a security. In essence, you purchase the option to buy (or sell) the security.

For example, let’s suppose you want to buy 100,000 shares of XYZ stock for $5 per share. But either you don’t have the money at the moment to buy that much, or you are nervous that the price may drop. So you purchase the option to buy at $5 per share for $5,000. Now you can legally buy XYZ stock for $5 per share, no matter what the share price does; the contract lasts about a month.

Suppose a few days later, XYZ Company releases better than expected earnings and says that they have invented a machine that will solve world hunger. Overnight the stock shoots from $5 per share to $50 per share. You exercise your option and you spend $500,000 to buy $5,000,000 worth of the stock. You turn around and sell it for a $4,495,000 profit ($5 million – $500,000 – $5,000).

Now let’s suppose the opposite happens. XYZ Company declares bankruptcy and goes under. The stock drops from $5 per share to $0. You can let your option expire worthless, and you are only out the $5,000.

That’s the easy part. The confusing part is that there are more options than just the option to buy. You can take four positions when trading options. You can:

Buy a call – This was our example above, you buy the option to buy at a specific price.

Sell a call – This is when you already have the stock, and you sell the option to buy to someone else.

Buy a put – This is if you own, or don’t own, the stock, and you buy the option to sell at a specific price.

Sell a put – This is when you own the stock, and you sell the option to sell to someone else.

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Confused? It’s ok, there’s a lot that goes into it. If you buy a call, or you buy a put, your maximum loss is the premium that you paid, and you’re under no obligation to buy or sell. If you sell a call or sell a put, then your maximum gain is the premium, and you must sell if the buyer exercises their option.

Options Contract

Is Options Trading Risky?

Now that we know what options trading is, let’s take a look at the risk behind it. The issue, however, is that not all options carry the same risk. If you are the writer (seller) you have a different risk than if you are the holder (buyer).

Call Holders – If you buy a call, you are buying the right to purchase the stock at a specific price. The upside potential is unlimited, and the downside potential is the premium that you spent. You want the price to go up a lot so that you can buy it at a lower price.

Put Holders – If you buy a put, you are buying the right to sell a stock at a specific price. The upside potential is the difference between the share prices (suppose you buy the right to sell at $5 per share and it drops to $3 per share). The downside potential is the premium that you spent. You want the price to go down a lot so you can sell it at a higher price.

Call Writers – If you sell a call, you are selling the right to purchase to someone else. The upside potential is the premium for the option; the downside potential is unlimited. You want the price to stay about the same (or even drop a little) so that whoever buys your call doesn’t exercise the option and force you to sell.

Put Writers – If you sell a put, you are selling the right to sell to someone else. The upside potential is the premium for the option, the downside potential is the amount the stock is worth. You want the price to stay above the strike price so that the buyer doesn’t force you to sell at a higher price than the stock is worth.

To simplify further, if you buy an option, your downside potential is the premium that you spent on the option. If you sell a call there is unlimited downside potential; if you sell a put, the downside potential is limited to the value of the stock.

Using Options to Offset Risk

Options contracts were initially conceived as a way to reduce risk through hedging. Let’s take a look at a few option strategies that utilize options to protect against risk. (For a quick primer, see Reducing Risk With Options.)

Covered Calls: While a covered call is a relatively simple strategy to utilize, don’t dismiss it as useless. It can be used to protect against relatively small price movements ad interim by providing the seller with the proceeds. The risk comes from the fact that in exchange for these proceeds, in particular circumstances, you are giving up at least some of your upside rewards to the buyer.

Protective Put: A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.

Puts by themselves are a bearish strategy where the trader believes the price of the asset will decline in the future. However, a protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.

Protective puts may be placed on stocks, currencies, commodities, and indexes and give some protection to the downside. A protective put acts as an insurance policy by providing downside protection in the event the price of the asset declines.

More complex option spreads can be used to offset particular risks, such as the risk of price movement. These require a bit more calculation than the formerly discussed strategies.

The Bottom Line

So, is options trading risky? If you do your research before buying, it is no riskier than trading individual issues of stocks and bonds. In fact, if done the right way, it can be even more lucrative than trading individual issues.

But it all comes down to whether or not you did your research. If the research points to the stock increasing in price soon (hopefully before the option expires), then you can buy a call. If research points to a stock decreasing in price, you can buy a put. If the research points to the option staying about the same, you can sell a call or a put.

10 Options Strategies To Know

Traders often jump into trading options with little understanding of options strategies. There are many strategies available that limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power options offer. With this in mind, we’ve put together this primer, which should shorten the learning curve and point you in the right direction.

4 Options Strategies To Know

1. Covered Call

With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write (or sell) a call option on those same shares.

In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the underlying stock’s value.

In the P&L graph above, notice how as the stock price increases, the negative P&L from the call is offset by the long shares position. Because you receive premium from selling the call, as the stock moves through the strike price to the upside, the premium you received allows you to effectively sell your stock at a higher level than the strike price (strike + premium received). The covered call’s P&L graph looks a lot like a short naked put’s P&L graph.

Covered Call

2. Married Put

In a married put strategy, an investor purchases an asset (in this example, shares of stock), and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price. Each contract is worth 100 shares. The reason an investor would use this strategy is simply to protect their downside risk when holding a stock. This strategy functions just like an insurance policy, and establishes a price floor should the stock’s price fall sharply.

An example of a married put would be if an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing because an investor is protected to the downside should a negative event occur. At the same time, the investor would participate in all of the upside if the stock gains in value. The only downside to this strategy occurs if the stock does not fall, in which case the investor loses the premium paid for the put option.

In the P&L graph above, the dashed line is the long stock position. With the long put and long stock positions combined, you can see that as the stock price falls the losses are limited. Yet, the stock participates in upside above the premium spent on the put. The married put’s P&L graph looks similar to a long call’s P&L graph.

What’s a Married Put?

3. Bull Call Spread

In a bull call spread strategy, an investor will simultaneously buy calls at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying and expects a moderate rise in the price of the asset. The investor limits his/her upside on the trade, but reduces the net premium spent compared to buying a naked call option outright.

In the P&L graph above, you can see that this is a bullish strategy, so the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off when putting on a bull call spread is that your upside is limited, while your premium spent is reduced. If outright calls are expensive, one way to offset the higher premium is by selling higher strike calls against them. This is how a bull call spread is constructed.

How To Manage A Bull Call Spread

4. Bear Put Spread

The bear put spread strategy is another form of vertical spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This strategy is used when the trader is bearish and expects the underlying asset’s price to decline. It offers both limited losses and limited gains.

In the P&L graph above, you can see that this is a bearish strategy, so you need the stock to fall in order to profit. The trade-off when employing a bear put spread is that your upside is limited, but your premium spent is reduced. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them. This is how a bear put spread is constructed.

5. Protective Collar

A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option for the same underlying asset and expiration. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This options combination allows investors to have downside protection (long puts to lock in profits), while having the trade-off of potentially being obligated to sell shares at a higher price (selling higher = more profit than at current stock levels).

A simple example would be if an investor is long 100 shares of IBM at $50 and IBM has risen to $100 as of January 1 st . The investor could construct a protective collar by selling one IBM March 15 th 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until March 15 th , with the trade-off of potentially having the obligation to sell his/her shares at $105.

In the P&L graph above, you can see that the protective collar is a mix of a covered call and a long put. This is a neutral trade set-up, meaning that you are protected in the event of falling stock, but with the trade-off of having the potential obligation to sell your long stock at the short call strike. Again, though, the investor should be happy to do so, as they have already experienced gains in the underlying shares.

What is a Protective Collar?

6. Long Straddle

A long straddle options strategy is when an investor simultaneously purchases a call and put option on the same underlying asset, with the same strike price and expiration date. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly out of a range, but is unsure of which direction the move will take. This strategy allows the investor to have the opportunity for theoretically unlimited gains, while the maximum loss is limited only to the cost of both options contracts combined.

In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a large move in one direction or the other. The investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.

What’s a Long Straddle?

7. Long Strangle

In a long strangle options strategy, the investor purchases an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset and expiration date. An investor who uses this strategy believes the underlying asset’s price will experience a very large movement, but is unsure of which direction the move will take.

This could, for example, be a wager on an earnings release for a company or an FDA event for a health care stock. Losses are limited to the costs (or premium spent) for both options. Strangles will almost always be less expensive than straddles because the options purchased are out of the money.

In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a very large move in one direction or the other. Again, the investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.

Strangle

8. Long Call Butterfly Spread

All of the strategies up to this point have required a combination of two different positions or contracts. In a long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. All options are for the same underlying asset and expiration date.

For example, a long butterfly spread can be constructed by purchasing one in-the-money call option at a lower strike price, while selling two at-the-money call options, and buying one out-of-the-money call option. A balanced butterfly spread will have the same wing widths. This example is called a “call fly” and results in a net debit. An investor would enter into a long butterfly call spread when they think the stock will not move much by expiration.

In the P&L graph above, notice how the maximum gain is made when the stock remains unchanged up until expiration (right at the ATM strike). The further away the stock moves from the ATM strikes, the greater the negative change in P&L. Maximum loss occurs when the stock settles at the lower strike or below, or if the stock settles at or above the higher strike call. This strategy has both limited upside and limited downside.

9. Iron Condor

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a bull put spread and a bear call spread. The iron condor is constructed by selling one out-of-the-money put and buying one out-of-the-money put of a lower strike (bull put spread), and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike (bear call spread). All options have the same expiration date and are on the same underlying asset. Typically, the put and call sides have the same spread width. This trading strategy earns a net premium on the structure and is designed to take advantage of a stock experiencing low volatility. Many traders like this trade for its perceived high probability of earning a small amount of premium.

In the P&L graph above, notice how the maximum gain is made when the stock remains in a relatively wide trading range, which would result in the investor earning the total net credit received when constructing the trade. The further away the stock moves through the short strikes (lower for the put, higher for the call), the greater the loss up to the maximum loss. Maximum loss is usually significantly higher than the maximum gain, which intuitively makes sense given that there is a higher probability of the structure finishing with a small gain.

10. Iron Butterfly

The final options strategy we will demonstrate is the iron butterfly. In this strategy, an investor will sell an at-the-money put and buy an out-of-the-money put, while also selling an at-the-money call and buying an out-of-the-money call. All options have the same expiration date and are on the same underlying asset. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other.

This strategy essentially combines selling an at-the-money straddle and buying protective “wings.” You can also think of the construction as two spreads. It is common to have the same width for both spreads. The long out-of-the-money call protects against unlimited downside. The long out-of-the-money put protects against downside from the short put strike to zero. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors like this strategy for the income it generates and the higher probability of a small gain with a non-volatile stock.

In the P&L graph above, notice how the maximum gain is made when the stock remains at the at-the-money strikes of the call and put sold. The maximum gain is the total net premium received. Maximum loss occurs when the stock moves above the long call strike or below the long put strike. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”)

Should You Trade Futures Contracts or Options?

It can depend on your risk profile and time horizon

Kanok Sulaiman / Getty Images

Deciding whether to trade futures contracts or futures options is one of the first decisions a new commodity trader needs to make. Even experienced commodity traders often waffle back and forth on this issue. Which is the better method for trading?

Contracts and options both have their pros and cons, and experienced traders often use both depending on the situation. Other traders like to focus on one or the other. It’s best to fully understand the characteristics of each when you decide how to trade commodities. From there, it’s just a matter of using the strategies that make the most sense for you.

Trading Futures Contracts

Futures contracts are the purest vehicle to use for trading commodities. These contracts are more liquid than option contracts, and you don’t have to worry about the constant options time decay in value that options can experience.

Futures contracts move more quickly than options contracts because options only move in correlation to the futures contract. That amount could be 50 percent for at-the-money options or maybe just 10 percent for deep out-of-the-money options.

Futures contracts make more sense for day trading purposes. There’s usually less slippage than there can be with options, and they’re easier to get in and out of because they move more quickly.

Many professional traders like to use spread strategies, especially in the grain markets. It’s much easier to trade calendar spreads—buying and selling front and distant month contracts against each other—and spreading different commodities, like selling corn and buying wheat.

Trading Options

Many new commodity traders start with option contracts. The main attraction with options for many people is that you can’t lose more than your investment, but the chance of running a negative balance is slim if you only risk a small portion of your account on each trade.

Trading options can be a more conservative approach, especially if you use option spread strategies. Bull call spreads and bear put spreads can increase the odds of success if you buy for a longer-term trade, and the first leg of the spread is already in the money.

Futures options are a wasting asset. Technically, options lose value with every day that passes. The decay tends to increase as options get closer to expiration. It can be frustrating to be right on the direction of the trade, but then your options still expire worthless because the market didn’t move far enough to offset the time decay.

Just as the time decay of options can work against you, it can also work for you if you use an option selling strategy. Some traders exclusively sell options to take advantage of the fact that a large percentage of options expire worthless. You have unlimited risk when you sell options, but the odds of winning on each trade are better than buying options.

Some option traders like it that options don’t move as quickly as futures contracts. You can get stopped out of a futures trade very quickly with one wild swing. Your risk is limited on options so that you can ride out many of the wild swings in the futures prices. As long as the market reaches your target in the required time, options can be a safer bet.

Both Futures and Options Are Derivatives

Think of the world of commodities as a pyramid. At the very top of the structure is the physical raw material itself. All the prices of other vehicles like futures, options, and even ETF and ETN products are derived from the price action in the physical commodity. That’s why futures and options are derivatives.

Futures have delivery or expiration dates by which time they must be closed, or delivery must take place. Options also have expiration dates. The option, or the right to buy or sell the underlying future, lapses on those dates.

Long vs. Short Options

Long options are less risky than short options. All that is at risk when you buy an option is the premium paid for the call or put option. Options are price insurance—they insure a price level, called the strike price, for the buyer. The price of the option is the premium, a term used in the insurance business. Commodity option prices are premiums reinforcing the nature of the price insurance, but they become the insurance company when you sell an option. The maximum profit for selling or granting an option is the premium received. An insurance company can never make more money than the premiums paid by those buying the insurance.

Commodities are volatile assets because option prices can be high. The price of an option is a function of the variance or volatility of the underlying market. The decision on whether to trade futures or options depends on your risk profile, your time horizon, and your opinion on both the direction of market price and price volatility.

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