Benefits of options trading

Advantages of options

Historically, options have been used in various cultures to secure the price of goods or commodities for future delivery. Key potential advantages of options trading include:

• Variety of strategies: whatever your trading style, options provide a range of strategies to cater to different risk profiles and market outlooks.
• Risk mitigation: know your potential loss upfront – the maximum loss for buying a call or put option is limited to the premium paid.
• Use of leverage: trading options with leverage enables traders to gain greater exposure to an instrument by putting up a pre-determined percentage of the full value of the trade, known as the margin requirement. Leveraged trading amplifies both gains, and losses. When going long on options with us, you would put up the full premium as margin for the trade.
• Speculate: options enable traders to profit from a range of price movements in the underlying asset, whether rising, falling, or remaining flat.
• Hedging: by trading on options, investors can protect their underlying stock portfolio investment from adverse price movements through hedging.

Variety of strategies

Options trading offers a range of strategies. We look at four popular options trading strategies, shedding light on how they work and their potential benefits.

Cash-secured puts

Cash-secured puts involves selling a put option while simultaneously setting aside the funds to purchase the asset if it drops below the option’s strike price.

If the underlying asset price stays above the strike price, the put option will expire worthless, and you will keep the premium paid to open the position. If the underlying asset price falls below the strike price, you will be obligated to buy the asset at the strike price, but keep the premium.

For cash-settled options, you receive a cash settlement based on the difference between the strike price and the underlying asset price, instead of delivery of the underlying asset.

This is a way to take advantage of market stability, or to potentially buy a stock at a lower price, while also keeping the premium paid.

Covered calls

Covered calls are a strategy where you hold a long position in a stock and sell (write) call options on that stock. You earn a premium from selling the call, but the potential profit is capped if the stock rises beyond the call's strike price.

This strategy provides an income stream on top of any dividends or gains from the stock, but limits the upside potential.

Short strangle

Short strangle involves selling an out-of-the-money call and an out-of-the-money put on the same stock with the same expiration date.

When you sell an option, you receive a premium from the buyer. In a short strangle, you collect premiums from both the call and the put options you sell. The total income you receive from selling these options is known the "premiums collected."

The maximum profit in this strategy is limited to the premiums collected, because once you've sold the options, the most you can gain is the income from the premiums. There's no other source of profit in this position.

This maximum profit is realised if the stock price stays between the strike prices of the call and put options until expiration. In this scenario, both options expire worthless, and you get to keep the entire premium as profit. Losses can occur if the stock moves significantly in either direction.

You can profit in a neutral market if the stock stays between the two strike prices. It's a strategy aimed at generating income in range-bound markets.

Long straddle

Long straddle is where you buy both a call and a put option on the same stock with the same strike price and expiration date. You profit if the stock moves significantly in either direction. The maximum loss is limited to the combined premiums paid for the options.

This strategy allows traders to profit from big price swings, whether upwards or downwards. It's a bet on volatility rather than a specific price direction.

These are just a handful of strategies available in options trading. Each have their own nuances, based on specific market conditions and trader objectives. As with all trading methods, it's crucial to understand each strategy fully and consider your risk tolerance.

Managing your risk

Options are used by some traders as a means of mitigating risk.

Defined risk: when you buy an option your potential loss is capped at the premium you paid, although it’s worth noting that you could lose more or less than the premium paid if, for example, you’re trading in different currency to your account currency, due to FX price fluctuations, in addition to a currency conversion fee. However, the option will expire worthless if the market doesn’t move enough to be in-the-money, so if you have multiple option positions which aren’t in-the-money, your overall losses will accumulate.

Flexibility: options allow you to make money whether the market is going up, down, or staying flat. This presents more potential opportunities to profit and diversify.

Hedging: by trading on options strategically, you can protect your wider investments from adverse market movements. Learn more about hedging below.

Hedging

A long put option can be used as a type of insurance against a drop in the price of an asset you already hold a position in. Using options to hedge can reduce short-term risk and limit any losses.

You may be able to buy a put option directly on the asset you hold, or on an index which is closely correlated to your portfolio, known as a proxy hedge. The goal is to offset any losses that may occur in your portfolio if there are adverse movements in the underlying market.

Example of options hedging

Your investment portfolio includes an investment that tracks the S&P 500, which is currently valued at $4,000. After a news announcement, you identify the risk of a potential market downturn that could negatively impact the value of your portfolio.

You decide to mitigate the risk by purchasing a European-style cash-settled put option on the S&P 500 index. The strike price of the put option is set at 3,900 points, with an expiry date three months from now.

The contract stipulates that if the S&P 500 index falls below 3,900 points by the expiry date, it will automatically exercise your right to receive a cash settlement for the difference between the strike price and underlying asset price of the S&P 500. This mechanism ensures that if the S&P 500 remains above 3,900 points, the option will automatically expire worthless, resulting in a loss limited to the premium paid.

If the S&P 500 falls below the strike price of 3,900 points, the contract will be exercised on the expiry date, and you will receive a cash payment corresponding to the difference. This payout will help offset any decline in the value of your investment portfolio tied to the index's performance.

This put options trade means that you’ve protected your portfolio against the adverse effects of a declining market, ensuring a measure of stability and risk mitigation.

Options differ from a standard stop-loss order, which is triggered automatically at a predetermined price level, though the execution price can differ from the trigger level in volatile markets. Options provide the flexibility to exit the trade based on market conditions up until the expiry of the contract, offering a strategic advantage in managing market exposure.

Risks and challenges of options trading

Trading options is based on backing an asset to move in a particular direction, and within a specific timescale.

Particularly with long options, if the underlying asset doesn’t perform as hoped in the stipulated timeframe, and the trader lets the contract expire, the premium cost is lost. The individual loss may not be significant, but if the same thing keeps happening, the losses can accumulate.

There is also a risk of external factors affecting an option’s value, including volatility, which will affect both long and short options. Higher volatility increases the value of long call and put options, as it raises the likelihood of substantial price movements, making these options more valuable due to their greater potential for profitability.

Conversely, for short call and put options, high volatility heightens the risk, as it increases the chances of significant price swings in the underlying asset, making it more likely the options will be exercised against the seller, potentially leading to a loss.

On the other hand, lower volatility decreases the value of long options, as the expected price movement of the underlying asset is less dramatic. However, it benefits short options by reducing the risk of the option being exercised, ultimately favouring the seller's strategy of options expiring worthless.