Why people trade options
Начало здесь и тут.
There are two major reasons but the subject of these mini-series is neither.
1. To benefit from correct predictions of the future via speculation and leverage
Let’s assume that I have developed a point of view that stock XYZ will more likely go up to $120 from the current $100 within the next year than down. I could decide to invest all my $10,000 in buying 100 shares of XYZ with the plan to sell if the price hits $120, my target price, or $90 where I will cut the losses. With this plan in mind, I stand to gain up to 20% or lose up to 10%. If my view on probability distribution is correct then the former is more likely than the latter so I can expect (I mean statistical expectation) to make some money. But both upside and downside are rather modest.
BTW. In trading, YOU MUST ALWAYS THINK ABOUT PROBABILITY DISTRIBUTION. In other words, you should always think about what can go wrong.
Alternatively, I can return to example 1 from earlier and buy an option with the strike $105 and maturity 1 year. By doing so I am expressing a very strong view that XYZ will trade above $105 plus the premium that I will have to pay to the seller with higher probability than it won’t. If XYZ is another proxy for S&P 500 then such an option could cost about $5, so my capital buys 20 contracts (100 shares each). If I am wrong and XYZ never trades above $105 then, alas, I lost all 100% of my capital.
But if it actually hits $120 let’s e.g. 3 months before maturity, I can follow the plan and sell the option. I could exercise my options and realize a $15 profit for each (120-105), so my total will be $30,000 = 2000*15. Hallelujah! I just tripled my money! However, exercising a call option before maturity is rarely a good idea. It is better to sell it b/c the market price will be above the exercise profit $15. Why? Because there is 3 months of life left in the option and the stock could continue going up, so the market price in this case would be around $17.5, so my capital after I sell sell options will be $35,000 so I made 250% profit on the trade!
Thus, my range of outcomes is [-100%,+250%] if I trade OTM call options vs [-10%,+20%] if I trade stocks. That’s called leverage. Potential of making 250% on a trade is very exciting, of course, but you should focus on the possibility to lose everything. This style of trading is not much different than playing roulette in a casino. DON’T GAMBLE.
2. To protect from unfavorable future market moves, aka hedging.
Let’s say I already own 100 shares of NVDA and I am really afraid that it could lose up to half the value within a year. I could live with the 10% loss but not more. I could buy a put struck 10% below the current price, about 100 at current prices. This will cost me about 10% of my capital if maturity is a year. Thus, I won’t lose more than 20% even if NVDA goes bankrupt and crashes to zero. In other words, by buying this put I chopped off left tail of the probability distribution. This is very similar to buying insurance on your real property. This is a legit use of options but it’s very expensive. (You usually overpay for options, especially puts. No, it’s not the reason to start selling them.) Therefore, I don’t recommend it. If you think that probability that price will go down is uncomfortably large, just sell it.
With this, I think I am done with preliminaries.
Update. I thank mi_b for pointing to the error in the original text.
There are two major reasons but the subject of these mini-series is neither.
1. To benefit from correct predictions of the future via speculation and leverage
Let’s assume that I have developed a point of view that stock XYZ will more likely go up to $120 from the current $100 within the next year than down. I could decide to invest all my $10,000 in buying 100 shares of XYZ with the plan to sell if the price hits $120, my target price, or $90 where I will cut the losses. With this plan in mind, I stand to gain up to 20% or lose up to 10%. If my view on probability distribution is correct then the former is more likely than the latter so I can expect (I mean statistical expectation) to make some money. But both upside and downside are rather modest.
BTW. In trading, YOU MUST ALWAYS THINK ABOUT PROBABILITY DISTRIBUTION. In other words, you should always think about what can go wrong.
Alternatively, I can return to example 1 from earlier and buy an option with the strike $105 and maturity 1 year. By doing so I am expressing a very strong view that XYZ will trade above $105 plus the premium that I will have to pay to the seller with higher probability than it won’t. If XYZ is another proxy for S&P 500 then such an option could cost about $5, so my capital buys 20 contracts (100 shares each). If I am wrong and XYZ never trades above $105 then, alas, I lost all 100% of my capital.
But if it actually hits $120 let’s e.g. 3 months before maturity, I can follow the plan and sell the option. I could exercise my options and realize a $15 profit for each (120-105), so my total will be $30,000 = 2000*15. Hallelujah! I just tripled my money! However, exercising a call option before maturity is rarely a good idea. It is better to sell it b/c the market price will be above the exercise profit $15. Why? Because there is 3 months of life left in the option and the stock could continue going up, so the market price in this case would be around $17.5, so my capital after I sell sell options will be $35,000 so I made 250% profit on the trade!
Thus, my range of outcomes is [-100%,+250%] if I trade OTM call options vs [-10%,+20%] if I trade stocks. That’s called leverage. Potential of making 250% on a trade is very exciting, of course, but you should focus on the possibility to lose everything. This style of trading is not much different than playing roulette in a casino. DON’T GAMBLE.
2. To protect from unfavorable future market moves, aka hedging.
Let’s say I already own 100 shares of NVDA and I am really afraid that it could lose up to half the value within a year. I could live with the 10% loss but not more. I could buy a put struck 10% below the current price, about 100 at current prices. This will cost me about 10% of my capital if maturity is a year. Thus, I won’t lose more than 20% even if NVDA goes bankrupt and crashes to zero. In other words, by buying this put I chopped off left tail of the probability distribution. This is very similar to buying insurance on your real property. This is a legit use of options but it’s very expensive. (You usually overpay for options, especially puts. No, it’s not the reason to start selling them.) Therefore, I don’t recommend it. If you think that probability that price will go down is uncomfortably large, just sell it.
With this, I think I am done with preliminaries.
Update. I thank mi_b for pointing to the error in the original text.