Options trading has become increasingly popular with retail traders since the start of the pandemic. This is partly due to the growth of retail platforms such as Robinhood that have allowed users the ability to trade vanilla options without much interference or education. The other reason is that with many having more time on their hands during lockdowns, building a working knowledge of options was possible. Here are our top five things to know about options trading.
Know your risk and exposure
The first two things to know and appreciate relate to risk management. Options inherently involve leverage. What we mean by this is that when you pay or receive the upfront premium, it’s usually only a fraction of the overall exposure that the option has. For example, you might buy a call option on Tesla at $1,200 worth one share, but only pay an upfront fee of $120. But if the share price rallies during this period, you get the benefit as if you had exposure on $1,200.
This can be of benefit if you buy a call, but it can be costly if you write options. For example, if you sell a call option, your potential loss is unlimited as the share price could soar higher. It’s important to understand what your exposure is.
In a similar manner, it’s easy to model your risk when buying options. It’s simply the risk that you lose your premium paid. But when selling (writing) options, the risk models are different. It’s important to have a system in place that can accurately tell you what risk you’re sitting on.
In some cases, the option will be used as a hedge. If you already own a stock, then it’s easy to sell call options. The risk is also lower, as your calls are covered by the fact you already own the stock.
However, let’s say that have sold a put on Stock X at $100. The delta on this option could be -0.6. The delta refers to the sensitivity in the option price relative to movements in the stock. So if the stock falls by $1, the value of the put would rise by 0.6. It’s key to know your delta so that if needed, you can delta hedge yourself to reduce risk.
In this case, I could simply buy 60 shares of Stock X, which would hedge my delta. This allows me to reduce my exposure to a large adverse move in the stock.
It’s a complex world out there
The world of options trading is like an iceberg. To begin with, buying calls and puts seems relatively straightforward. But in reality, you can find yourself in a hole of complex structures that combine multiple calls and puts at different strike levels and different amounts. Don’t feel the need to get overly ambitious with options trading until you are completely comfortable with it.
If you think this article has been a bit of doom and gloom, the final thing you need to know is a positive one. Options trading can be very lucrative. With the use of leverage, you can generate high returns in a short space of time. No wonder it has become so popular in recent times.
Overall, options trading is definitely something worthy considering. However, ensure you’ve done your research before jumping into this opaque world.