For those readers who have not contemplated options I am going to write a short series of articles in the coming weeks - in small ‘bites’ at a time. I want to illustrate just how safe options are and how useful (and easy) they can be as either a defensive or offensive strategy.
There’s no denying that the current market is a roller coaster ride. Have you thought of using Exchange Traded Options to limit your risk? Admittedly there’s quite a range of leveraged products available now, but options are still one of the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income.
There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. It is essential to become familiar with the inner workings of both. Every strategy you learn from this point on depends on your thorough understanding of these two kinds of options. Options are normally sold in contract lots of 1000. That means one option contract controls 1000 shares.
Simply stated, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock at a specified price until the 3rd Thursday before the last business Friday of the expiration month. There are no margin requirements if you want to purchase an option because your risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless. However, option sellers have an obligation to buy (short put) or sell (short call) the underlying instrument, at the specified strike price, if their option is exercised by an option holder. Therefore, selling an option to open a position may require a healthy margin.
Let’s look at a current example of a long call strategy using National Aust. Bank (NAB). This bank has dropped a lot recently and could be ready for a rise. The stock is currently trading at around $26.00, having risen off its recent lows of $24. Instead of buying the shares to trade this upswing, you could buy the October $27.00 Call option. It has an asking price of $1.50. The drawing shows a risk graph for this basic option strategy; note how the maximum loss is represented by a vertical line. This trade uses a slightly “Out of the Money” option.
The benefit of using an option instead of buying the shares is that we don’t have to come up with the $26000 necessary to pay for 1000 shares. Also, what if NAB continues to drop, our maximum risk is now only $1500.
Risk Graph of NAB October $27 Long Call
click to enlarge
The price of this option is $1.50, for a total cost of $1500 per contract ($1.50 x 1000 = $1500) plus commissions. The maximum risk is the price of the option contract ($1500). The maximum reward is unlimited to the upside as NAB stock continues to rise. The breakeven is calculated by adding the strike price ($27) to the premium of the call option ($1.50). In this example, the breakeven is $$28.50 ($27 + $1.50 = $28.50). This means that the trade starts to make money if NAB is above $28.50 at expiry. However, given the way that options work, your trade will start to show a profit before then if NAB continues to rise.
I will continue this series of articles on what options are and how to use them over the next few weeks.
Remember, you always have options.