As the word literally implies, “options” gives investors choices of various different avenues for investment. Options enable investors to adapt their strategies based on prevailing market conditions. Approximately 40 million options contracts are traded daily, highlighting their’ widespread usage and popularity. In May 2023 alone, the Options Clearing Corp cleared a staggering 949.1 million contracts, emphasising the market’s significant volume and activity. For context, the options market actually rivalled the daily volume of the New York Stock Exchange, with approximately 38.3 million contracts traded daily in 2022.
By utilising options, investors can effectively manage risk by limiting potential losses. They can also hedge their positions, protecting themselves from adverse price movements. Additionally, options offer the advantage of leveraging with a relatively smaller investment amount as compared to equities. This leverage amplifies potential profits if the market moves in the investor’s favour. Moreover, the flexibility of options provides investors with the choice to take bullish or bearish positions, enabling them to align their strategies with their market outlook and investment goals.
Equities and options share certain similarities, but they also have distinct differences (see Chart 1). It is important to note that options contracts are highly diverse, with approximately 1.5 million different variations available. These options contracts are based on a variation of an estimated 8,000 types of underlying assets. Unlike equities, options are exclusively traded on exchanges, which means there is no off-exchange trading for options.
Currently, there are a total of 16 stock exchanges and 16 options exchanges in operation, competing for orders. Prominent exchanges include Nasdaq, the New York Stock Exchange, and the Cboe Exchange, which is currently the largest options exchange in the US. These exchanges provide platforms for equities trading.
Options made simple
An options contract is an agreement between two parties, the buyer and the seller. The contract gives the right to the buyer of options to buy/sell a certain number of underlying assets from the seller of options at the exercise (strike) price within a specified time in the future.
The buyer of an option holds the right, but not the obligation, to buy or sell the underlying asset within the specified time. The seller of an option does not have such rights and can only assume the obligation as stipulated in the contract.
Four basic options strategies
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Long call
When you pay a premium for a long call option, it gives you the right to buy the underlying stock at a specific strike price stated in the call option. Calls may be used as an alternative to outrightly buying the stock. You can earn a profit if the stock rises, without taking on the downside risks that would result from owning the stock. As seen in Chart 2, as the share price increases, the value of the options will continue to rise to an ideal level of unlimited profit. Subsequently, the risk for buyers of a call option is only limited to the premium paid on the call option.
Long put
A long put option gives you the right to sell the underlying stock at the strike price. The long put option can be used as an alternative to shorting the underlying stock. You can profit if the stock price drops, without taking on the downside risks that would result from shorting the stock.
As seen in Chart 3, as the share price decreases, the value of the option will continue to rise; ideally to a level of unlimited profit or until the share price reaches 0. Subsequently, the risk for buyers of a long put option is only limited to the premium paid on the put option.
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Covered call
A covered call strategy involves selling a call option to collect premiums as income. However, to execute this strategy, you will need to have the underlying stock. Selling a call option obligates you to sell 100 shares of the underlying, which would be a bad idea if you do not already own the shares. Without the shares at options expiry, you will be required to buy 100 shares from the open market, and then deliver them to the option buyer at the strike price; hence the term “covered”.
If you already own the shares of the underlying stock, and the call option buyer decides to exercise the option, you will be obligated to deliver the 100 underlying shares at the specific strike price. In this case, you will earn the premium of the option and also the amount from delivery of the underlying at the strike price (this strike price can be your “take profit” level for the underlying stock).
In another scenario, if the stock does not surpass the strike price and the call option expires worthless, the seller of the call option stands to benefit by retaining both the full premium received and the underlying shares. This strategy is widely adopted by investors as a means of generating supplementary income while retaining ownership of desired shares. Similar to that of holding dividend-paying stocks, selling call options can also generate a form of “dividends”. Moreover, it is even possible to sell call options on stocks that do not offer dividends, providing an additional avenue for income generation.
Let’s take Apple as an example, where the stock price is US$184.92 (see Chart 5). Suppose an investor sells an Apple call option with a strike price of US$200, expiring on July 14, 2023, for a one-month expiration. They can receive a premium of approximately US$240. This means that the investor will keep the premium if the Apple stock does not exceed US$200 by July 14, 2023. However, if the stock price surpasses US$200, the investor will be obligated to deliver 100 shares of Apple to the option buyer at the agreed price of US$200, regardless of how much the stock price has appreciated.
Protective puts
The protective put strategy combines the ownership of the underlying shares with the purchase of a long put option. By buying a put option, investors can effectively hedge against both systematic risk(s) and company-specific risk(s). This insurance serves as a short-term safeguard, especially for investors who are looking to maintain a positive longterm outlook. The long put position acts as a form of protection against potential declines in the share price of the underlying asset. With a long position in the underlying shares, profit will continue to increase as the share price increases. However, the losses will be limited as a put option is put in place (to safeguard in case of a fall in share prices). Therefore, this strategy is called the protective put as investors protect their long position using a put option.
An example
Upon purchase of a new car (underlying), it is necessary to purchase precautionary insurance (put options) before driving it. When purchasing an insurance policy, be it for automobile, health, life or home, a premium has to be paid to secure the provided coverage. This payment mirrors the role of the options buyer plays in the market. However, it is common for individuals not to require the use of their insurance, resulting in the insurance company retaining the funds paid. This reflects the role of the options seller.
During an earnings season, investors often find themselves wanting to hold onto their shares but are unsure about the company’s future guidance or earnings results. Therefore, investors may choose to purchase put options as a means of protection for their shares from potential whirl winds in the market.
In summary, options provide investors with a versatile and adaptable approach to investing. With millions of contracts traded daily, options have gained widespread popularity in the financial markets. With the recent release of options trading on the POEMS 3 platform, investors now have even more opportunities to participate in this market. With options, investors can now potentially manage risk, hedge positions, and potentially amplify profits through leverage. Furthermore, options provide the flexibility to take bullish and bearish positions, aligning strategies with market outlook and investment goals. As a result, options have become an essential tool for many investors seeking to navigate dynamic market conditions and optimise their investment strategies.
Thng Xiao Xiong is UK equity dealer at Phillip Securities
