In the recent series of articles, we have unpacked how and when derivatives are best used and why investors incorporate them in their investment portfolio. In this article we will take a closer look at a specific type of derivative that has in recent years, especially during Covid, gained increased popularity – options. The reason for options’ popularity is that they provide flexibility where the investors can lock in a price without having the obligation to buy.
An option is a contract giving the buyer the right—but not the obligation—to either buy or sell the underlying asset at a specific price, known as the strike price, on or before a certain date. In exchange for owning this right the investor pays the writer of the options contract a fee known as a premium. The price of the premium is determined by various factors such as demand and supply for the specific contract as well as the likelihood that the investor will exercise their option. As explained in previous articles, derivatives and then also by definition, options, are always based on, or derived from, an underlying asset, which are usually equity, bonds, forex or commodities. Usually, the investor only owns the contract and not the underlying asset, but they will have the option of ownership if they exercise their right.
We get two types of options – a call option which gives the investor the right, but not the obligation to buy the underlying asset at the strike price, and a put option which gives the investor the right, but not the obligation to sell the underlying asset at the strike price. To take it one step further, investors can either own a long or a short put or call options which means they either write the contract or own the contract.
A short call for example is used as a trading strategy when an investor believes that the price of the underlying asset will drop, meaning it is considered a bearish trading strategy. It involves selling call options, meaning the seller (also known as the short investor) must deliver the underlying asset if the option is exercised by the holder of the option, but will earn the premium in exchange for this.
The success of a short call strategy therefore rests on the option contract expiring worthless, meaning the option holder does not exercise their right as is stipulated in the contract. This will happen if the price of the underlying asset falls below that of the strike price (which is the price at which the option owner has the right to buy the underlying asset), meaning they will rather buy the underlying asset in the market which have a lower price than buying if from the option writer at the strike price. Short calls have limited profit potential since the investor will only earn a premium while the theoretical risk can be unlimited given that the fluctuation in the underlying asset price is limitless – meaning short calls must be used by experienced investors and traders.
Long calls and short puts will be profitable should the underlying asset price increase and is therefore used by bullish investors while short call and long put options become profitable when the underlying asset price falls. Derivative traders, and especially hedge fund traders, often use a combination of these four different types of option strategies to manage their risk and maximise their profits, if they have a conviction of the underlying asset moving in either direction.
Like all investment choices you make, you should have a clear idea of what you hope to accomplish before trading options. Before deciding to enter into any option strategy it is advised to do some simple calculations to find the maximum gain, maximum loss and breakeven points of the strategy you are considering to implement as it will be a good test of your risk tolerance. Options profit calculators are available online and will let you view the returns and profit or loss giving you a clear indication of the potential risks and returns you are taking on.
As with any other type of investing, it’s best to educate yourself thoroughly before diving in and online simulators are also available to assist in this regard. If it is, however well understood, option strategies do have the potential to add depth, flexibility and risk management to your portfolio that can enhance your overall investment portfolio.
