The Hows of Options Trading
Buying shares, stocks, and bonds have long been around, proving to be a viable investment option for whatever age, social status, or financial capacity. Because they are bought in units, investors of all types have a say on how much or how many shares they can buy, giving them a sense of authority, control, and satisfaction in their investment choice.
But what most investors, especially the newbies, don’t factor in one of the most important elements of this type of investment: risk.
This has caused the recent emergence of a type of trading security that addresses the risk factor of this investment while also exponentially growing someone else’s investment opportunity.
Think of it through this example. Say you have saved up enough to buy yourself a Mercedes Benz Class A 180 Style at roughly $124,000. It’s such a precious and valuable asset that you want to protect it.
So what do you do? You buy car insurance, which now financially protects your Mercedes in case you get into an accident.
Well, options trading is like insurance for your stocks or shares. The primary concept of options is you as an investor have a risk to undertake or absorb in your investment, but you are willing to pay another investor to take away your
risk and let him assume that risk, of course with a corresponding cost or fee.
Let’s take a closer look at how it’s applied.
Options Trading Applied
As Singaporean locals, we are all excited to support our homegrown companies and startups. So let’s take a “little” mobile classifieds app called Carousell (note the sarcasm with the word little, since Carousell raked in a whopping $85 Million in recent history).
Your wife loves the app and has both sold and bought items off of it. You saw it as a nice investment and you just want to try it out because you’re new at this. So you bought 50 shares at $100 per share. That’s $5,000 dollars in risk.
Remember our Mercedes Benz analogy and how you bought car insurance for it? You can also do the same with your $5,000 investment. This is called a put option.
You can buy an option from any other trader who has agreed to take on your risk, just like an insurance provider, for a fee.
So hypothetically, another investor offered you an option of $300 for your $5,000 investment. You took it and then went ahead with your merry way.
A few months later, Carousell has announced a merger with another tech company, thereby increasing the price per share of their stocks to $120 from $100. This now allows you to make a profit of $1,000.
However, you paid for the put option worth $300 to protect your investment. This now gives you a net profit of $700, which may give you a feeling that buying an option wasn’t worth it.
But let’s look at it the other way around.
What if instead of Carousell’s stocks increasing to $120, it plummetted to $60 due to a change in management that has caused investors to by nervous and shifty? How does your put option apply to that?
In a regular scenario, you should be sulking over a loss of $2,000. But since you bought the option from your fellow investor, you can immediately sell your shares at the price you bought it prior to its decrease, which is at $100.
Therefore, you are only financially set back $300 for the cost of the option. The cost of your shares was hedged at the price that you bought it, so it wasn’t affected by the stock plummeting.
Your investment was risk protected, and it’s now the fellow investor who offered you the option who ends up incurring the $2,000 loss because he is obligated to buy it back from you at the original price per share.
A Smart and Convenient Way to Invest
What’s also great about options is that you don’t necessarily have to own a stock to trade them. Unlike shares or bonds, these aren’t documents or actual pieces of paper that you have to physically hold on to. You can virtually trade for them in and out of the market. It’s quick, convenient, and just right for an investor with a quick-paced life but still wants to be wise in his investment choices.
Yes, your investor friend kept the $300, but incurred the loss. I’d say that was a very good financial decision on your end to have bought the option.
Watch out for Part II of this series, as we go more in-depth about options trading, its three elements, and simple tips to maximize them.
