Understanding Options Trading

October 27, 2013
By Vlad Karpel

Trading options isn’t as easy as trading stocks, but it’s a great way of hedging a portfolio’s position and getting some leverage for a low cost. As a hedge, options work like insurance contracts, protecting for “damages”. As a leveraged instrument, options offer traders a way of making huge profits with few funds. But, unfortunately, people tend to miss the link between profit potential and probability and end up losing money most of the time, even if just in small amounts.

When you evaluate a possible trade, you should take into account its profit potential. You also can’t ignore the probability of achieving that profit. Of course, winning the lottery will turn you into a billionaire at an extremely low cost, but the odds of that happening are very slim. The same type of thing happens when one is trading options. A trade with a very low risk/reward ratio (low cost, high profit potential) carries a low probability of ending in a profit. Basically, you will end in the red most of the time.

The price of an option follows a normal distribution, meaning that if we build a chart with prices on the x-axis and P/L on the y-axis, the distribution of profit will have the form of a bell curve. The further from current price that the expected price is, the lower the probability of that happening becomes. This means that a call option with a higher strike will be less likely to make you a profit.

The example chart below is for a $171 SPY call, expiring in two days, at a time SPY is trading at $171.50. The blue line shows the trader’s profit. The higher the underlying price, the higher the profit will be. The green shaded area is the bell curve that shows the probability of any given price happening. In the case depicted below, the probability of SPY rising to $173.62 is just 14.89%. The short price interval is between $169.54. $173.62 covers 70% of the probability.


With the above information in mind, don’t forget to check the probability of ending with a profit before buying those deep, out-of-the-money, options. Although they are cheap and expose you to large profit potential, it is best to calculate your chance of success before investment.

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Besides considering the odds, an options trader should also take into account five specific options characteristics.

1)Option prices are affected by several factors. Even when you are right about the direction a stock price will take, you may still take a loss. Option prices are affected not only by the underlying price but also by interest rates, volatility, dividends, and time-to-maturity. Using the example above, let’s say you think SPY will rise and you decide to buy the $171 option, priced at $2. If SPY rises to $172, you will make a loss of $1 per option, even though the stock effectively rose.

2)Options do expire. Unlike a company, which is an ongoing concern without an expiration date for its business, an option has a maturity date. At that point in time, the option ceases to exist. It expires and is no longer valid.

3)Selling options may force you to buy stock. When you sell a put or call you may be forced to buy the stock at the expiry date even in the case that you make a profit. This has strong financial implications that you should be aware of.

4)Position sizing is key. Options are a leveraged instrument, meaning you can build a position at a fraction of its cost. In the above example, instead of paying $171.5 for each SPY share, you are required to pay just $2. To hold 1,000 shares you would need $171,500, while just $2,000 to hold the options.

5)Options’ value suffers from time decay. When all else is held constant, the closer to the expiry date and the lower the value of the option. This happens because as the maturity date approaches, uncertainty will turn into certainty and options will be valued without any markup on their intrinsic value. In the above example, you were paying $2 for a $171 option when its intrinsic value was just $0.50. That’s because the underlying was trading at $171.5. As maturity approaches, the $1.5 markup will decline until reaching zero.

As you can see, options are a powerful investment tool that can add value to your portfolio. However, they need to be correctly mastered. When you move from stocks to options, the game changes from stock picking abilities to risk managing qualities.

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