What exactly is options trading?
“The Big Short” fame Dr Michael Burry bought a lot of put options recently, to bet against the US market indices. But why not simply short the index or major stocks directly? Why use another instrument?
Well, options have a lot of inherent advantages when it comes to trading. We’ll talk about that but first just let's understand what options are briefly. An option is a contract that gives a trader or investor the right to purchase or sell a benchmark, an ETF, a commodity, a currency, a stock, or all of the above at a certain price for a set period of time.
There are two types of options: calls and puts. You buy call options when you expect the price of the underlying asset to increase, and you sell call options when you expect the price of the underlying asset to fall or stay in a range. Conversely, you buy put options when you expect the price of the underlying asset to decrease, and you sell put options when you expect the price of the underlying asset to rise or stay in a range.
In other words, you buy either the puts or calls when you expect momentum and sell puts or calls when you expect either no momentum or momentum in the opposite direction of the contract type (put/call).
So what are the advantages of these contracts over normal stocks? One, leverage: you only need to pay a “premium” to trade options and not the entire contract value. And there is no room for any malpractice since these prices are set by mathematical models.
Two, decreased risk: since the amount locked in options is lesser (the premium) than stocks or other instruments when you trade the same size, your risk is typically the least with options trading.
Three, flexibility of strategies: given the nature of options contracts, you can adjust by buying or selling more contracts during an ongoing trade to make it profitable later or reduce the losses.
Four, hedging: options can be used to hedge against volatility in the market. Exactly how that is done, I’ll discuss in a later article.
But having talked about the pros of options, it is important to consider the pitfalls when trading options. You can read these up in detail on the internet if you’re interested because I’ll have to talk about these in detail in a later article only.
One, option sellers are open to big losses in the event of big one-sided movements.
Two, option buyers need to keep in mind the time left before the expiry of the contract.
Three, options trading typically attracts higher charges than the underlying assets by the brokerages.
Four, liquidity problems are commonplace with many options contracts due to most people flocking to the ones that can generate profits with higher probabilities.
As I said in the beginning, Dr Burry bought a lot of put options against the US market. So does he know something we don’t? We’ll have to wait and see. But you can read more such articles from me here. And do let me know if you want a specific topic covered. Subscribe for free to receive more posts like this every day!