A Brief Introduction Into Option Trading
One of the reasons why option trading is so scary for new investors is because of the plethora of options available, in terms of type of strategy, expiration date and strike price. One option could send your value to the moon, while the other could drive it straight into the ground. Therefore, finding the right option is essential to maximizing your success and profit. So which option is the right one to trade?
Here are seven steps to help you identify the right option:
- Choose the underlying asset
- Understand your investment objective
- Decide your risk-reward payoff
- Figure out the volatility
- Identify events
- Plan a strategy
- Establish option details
Choose the underlying
Before you can buy an option contract, you need to choose which asset you want to buy a contract for. Is it a stock, commodity, ETF? Everyone has their own way and resources to screen for the right asset (smart investors use www.toggle.ai).
Kate is a big fan of healthy eating and buys 1000 shares of Sweetgreen (NYSE:SG) at $29.24 per share.
Understand your investment objective
Once you know what underlying asset you want to trade, you need to know your objective so that you can decide the option strategy. Are you speculating on a large bullish or bearish move? Or are you trying to hedge a current position?
Do you want to earn a profit from selling the option premium or do you want to buy/sell an underlying asset? Different traders use options for different reasons: some want to make an income but others use options to speculate or hedge. Therefore, you must decide the objective of the trade before you can jump into the next step.
Kate is worried that the price of SG might fall by 5% over the next few months because Cava ( a competitor) has been performing very well.
Decide your risk-reward payoff
Dependent on your appetite for risk, your option strategy will be different. If you are a risk averse investor, then you might want to stick with leap call options. These are longer term options (more than 9 months till expiry) that carry similar risk to buying the underlying stock, except for cheaper since you’re not actually paying to buy the stock, but only the right. If you’re a riskier investor, you might want to write puts or enter deep out of the money positions, in hopes of a higher profit. Remember, the riskier the position, the higher the potential profit, but the higher chance of loss too.
Kate does not mind a little risk but wants to protect her stock position from downside risk
Figure out the volatility
As previously mentioned, the implied volatility of an option determines its price. The best strategy is to compare a stock’s implied volatility with its historical volatility and the the volatility in the general market - this will give you an idea of the stock’s implied volatility relative to the asset and rest of the market.
The implied volatility tells you whether other traders are expecting a large swing in the stock. A high implied volatility will result in a higher premium for the option, making it more attractive as traders think the volatility won’t increase anymore. A low implied volatility means that the premium is lower, which is cheaper to buy if a trader thinks the stock will swing soon. The aim is to buy an option with a low premium (and volatility), in hopes for the volatility to increase, causing the premium to increase too.
Implied volatility on in-the-money put options (strike price of $30) is 17.38% for one-month puts and 16.40% for three-month puts. Market volatility is currently 13.08%
Events can have a large impact on the implied volatility, even before it actually occurs. There are 2 categories of events: market-wide and stock-specific.
For example,Omicron outbreaks and accelerated tapering are market-wide events while an Astra rocket hitting orbit for the first time is a stock-specific event. Such events cause a spike in asset volatility and hence, the value of the option.
You should identify events which could have a large impact on the underlying, as this influences your decision about the right time frame and expiration date for the option trade.
Cava’s earnings report comes out in just under 2 months, which means the put option should extend to 3 months out, to protect Kate from downside Sweetgreen could see after Cava’s earnings report.
Plan a strategy
Depending on your investment objective, risk-reward payoff, level of volatility and key events, you can make an easier decision on which specific option strategy you want to use.
For conservative investors who just want to trade on the option premium, a covered call would be a good strategy as it involves writing calls on stocks already in your portfolio.
On the riskier hand, if you think the market is headed for a decline, you might want to buy puts on the major market indices.
Each strategy is dependent on you.
Kate buys puts to hedge the risk of a decline in Sweetgreen stock’s price.
Establish option details
Now that you know which option you want to purchase, all that remains is deciding the details of the option: expiration date, strike price and option deltas. For example, if you want to buy an option at the lowest cost, you would look at a call with the longest expiration which will be deep out-of-the-money.
$30 strike-price puts with a 3M expiration, available for $1.19 each.
For Kate to hedge her Sweetgreen position, she must purchase 10 put contracts (each containing 100 shares). Her total cost for the put position is $1.19 * 1000 = $1,190
If the price of the stock drops, the hedge kicks in, as the gain from the put option offsets the loss from the stock position. If the stock stays unchanged at $28.24, the value of the put option would be $0.76 ($30 - $29.24), which means Kate gets back $760 out of the $1190 she invested, when she closes her position.
If Sweetgreen’s price goes above $30, Kate would receive profit on the increase in her stock position but would have to forfeit the $1190 paid for the put position.