Options Trading: A Fundamental Strategy
In the past, I have written extensively on day trading strategies. I have explained the various strategies one can use to generate alpha in his day trading. Some of the strategies I have explained before are: arbitrage, hedging, scalping, events-driven, and trend following strategies. In this article, I will focus on another strategy (options) that is mostly used by major financial institutions and experienced traders.
Options trading is a form of derivatives trading which gives one a right (but not obligation) to buy or sell a particular asset. The easiest way to explain this is in form of a farmer who grows soy beans and a buyer. The two wants to maximize their profits. Therefore, if the price of soy beans is $10, the buyer can decide to sell it at the current market price. However, the buyer might approach the farmer and promise him to buy his produce after a month for $15. The farmer might agree to this because it will assure him a better price in a month’s time. On the other hand, the buyer will benefit in case the price of soy beans rises above $16 during that time. This is what options is all about. It can be used to speculate the price of currencies, commodities, equities, and other assets.
In options trading, there are mainly three people involved. There is the buyer who is known as the holder and the seller who is known as the writer. For a person to sell you the option, he will need a premium. This is the option’s price.
Options Trading: Buy Call
In options trading, one option you have is known as the Buy Call. Buy call gives you the right to BUY an asset at a specific date and strike price in the future. It however does not give you the obligation to buy the asset or currency. To do this, the holder will have to pay a premium upfront to the seller of the option. The profit scenario will happen if the asset moves up in price. A good example of this is explained below.
Assume that you are a holder and you buy the option to buy the Euro against the dollar in three months’ time at the strike price of 1.3900. Assume the premium price is $10. If the price of EURUSD is below 1.3910 at expiry, the holder of the pair will not have the incentive to exercise the option. If the price rises on expiry, then the holder will be in a profit position.
In this example, if the option expires at 1.3940, then you will make $30.
Options Trading: Sell call
This is the opposite of the buy call option explained above. In this strategy, the seller becomes the writer of a call option. Therefore, he will be required to honour the terms of the options contract. A good example is explained below.
If you decide to sell the option to buy the GBP against the dollar in two months time at a premium of $20 and the strike price is 1.39. If the price of the pair is below 1.3920 then the seller will keep the premium. If the price rises above 1.3920, the seller will be in the loss area. As a seller, your profit is limited to the premium received but the loss is unlimited.
Options Trading: Buy Put
When you buy a put, you pay a premium to buy the right to sell. The holder of the put option will have an unlimited upside when the spot price moves below the breakeven point.
Options Trading: Sell put
As the opposite of buying put, this is an option where the seller becomes the writer of the put option. The seller will receive the option upfront.
Other terms that you must understand when trading options are: expiration date (this is the date when the option contract expires), strike price (price when the option will be exercised), tintrinsiv value (the difference between predefined rate and the current rate), and money value (difference between the option premium and the intrinsic value of the premium).
Options Trading – Useful Links