“Huh? Why is this so complicated?” Well, almost all financial instruments are complicated, but with this guide, we hope to make it all a little less confusing. Options and CFDs are the more common financial derivatives that you’ll see when you register with a broker. So, let’s touch on those first!
Financial derivatives refer to financial instruments that derive value from a separate asset, like a share or a group of assets. In other words, these underlying assets act as a benchmark for the value of a financial derivative. Shares, bonds, currencies, indexes, and commodities are common examples of underlying assets.
For example, if you have a financial derivative tied to Apple shares and the price of Apple shares rise, then your financial derivative's price is also likely to go up.
Options are a common form of financial derivative that you may encounter. An options contract is always between a buyer and a seller. Depending on the type of option, the buyer has the opportunity to buy/sell a given underlying asset, such as a share, before or on a predetermined future date. The price at which the buyer buys/sells the underlying asset is fixed. This price is called the strike price.
The buyer does not have an obligation to exercise this right, meaning the buyer can choose whether to buy/sell the asset or do nothing at all (i.e. it's the buyer's option). Once the predetermined date arrives, this right expires.
An options contract gives the buyer the right to buy or sell the underlying asset at the strike price, but not both. The right given is dependent on the type of option in the contract.
Call Option: a call option gives the buyer the right to buy the underlying asset before or on a predetermined date in the future.
Put Option: a put option gives the buyer the right to sell the underlying asset before or on a predetermined date in the future.
Let’s take a look at a Call Option to see how options work.
You have bought:
If the price rises to $7 on 31st December, then you will exercise your call option and purchase the share in Apple at the strike price of $5 each. This will cost you $500 for the 100 shares stated in the contract. If you sell the shares immediately at the market price of $7, you will earn $700 for the 100 shares. Your payoff from this options contract will be how much you earned at the end, which is $700 - $500 = $200.
Don’t forget that you had paid a premium of $80 for the options contract on 1st December as well! As such, your total profit for the options contract will be $700 - $500 - $80 = $120. You will have made $120 on your initial outlay of $80, or a profit of 150%. Compare this with the gain in the underlying share over the same period of just 56%. This is the power of leverage!
Your payoff is positive in this case because the market price of the Apple shares has risen. When the option is in a money-making position, we call it In-The-Money, or ITM for short. Let us look at when the option is in a losing position, or Out-Of-The-Money (OTM).
Same as before, you have bought:
If the price fell to $2 on 31st December, then you will not exercise your call option because you may buy the share at $2 from the market instead of the strike price of $5 from the option seller. Remember that you are under no obligation to exercise your call option. It is an “option” after all! Thus, your payoff will be $0 since the option will simply expire.
Alas, you had paid a premium of $80 on 1st December, so your total profit will be -$80, and you would have made a loss. Had you just bought the shares instead, you would have lost 56% over the same period, but instead, you have lost 100% of your initial outlay. This is also the power of leverage!
Once again, using the same factors as above:
However, this time, the market price of Apple shares has fallen to $0.50 on 31st December. Once more, you will not exercise your option, so your payoff is $0 as well. Your profit will be -$80, i.e. a 100% loss as before, in Example 2, even though this time the share price of Apple dropped by 89%!
The examples above show that the main benefit of options is that there is a payoff when the option is ITM, yet there is no negative payoff when the option is OTM. It will always be 0. Hence, no matter how Out-Of-The-Money your option is, your minimum payoff is always $0, and your maximum loss is always the premium you paid upfront. However, there is no limit to the amount of payoff that you could potentially have, based on the appreciation of the underlying asset.
Now, let’s use the same setup but with a Put Option instead:
Following Example 2, say the market price has now fallen to $2 on 31st December. Recall that a put option gives you the right to sell the asset at the strike price of $5 per share. So, at this point, you can buy 100 Apple shares from the market for $200 and exercise your put option to sell them at $500 to the option seller. This gives you a payoff of $500 - $200 = $300 and hence a profit of $500 - $200 - $80 = $220. As you can see, unlike an OTM call option, the put option you bought will be ITM.
In essence, if you expect the underlying asset price to rise, you should buy a call option; if you expect the underlying asset price to fall, you should buy a put option.
Instead of buying an option, you can sell it. The decision of whether to exercise the option or not will still be with the buyer and not you as the seller. Hence, if you should take up the position of a seller, you will have no say in the matter.
Long Position: you have bought the call or put option from another party. You are known as the buyer.
Short Position: you have sold the call or put option to another party. You are known as the seller or the writer.
Your payoff and profit will be the direct opposite of your counterparty. In other words, your payoff as the writer of the option can never exceed $0 and will always be negative or 0. Because of the premium you received at the start from the buyer, your profit can be positive.
It is extremely important to note that:
When you buy an option, when your loss is limited to the amount that you paid as premium and the profit is unlimited.
When you are the writer of an option, your profit is limited to the amount that you received as premium and the loss is unlimited for call options.
When you purchase options online, which we will discuss at the end of this article, you will be exposed to a few extra data points. These data points are known as the Option Greeks, and they provide insights into how the price of a particular option typically moves when factors change. The main ones appear in the infographic above:
Not all investors keep options until their maturity/expiry date. Options traded on an exchange can be bought and sold at any time. Like other financial derivatives, options themselves have a value and can be traded like shares and bonds for a profit.
The value of options consists of two important components:
1) Intrinsic Value: this is the option's payoff if you exercise it now, i.e. Market Price - Strike Price for call options and Strike Price - Market Price for put options.
2) Time Value: this is associated with the possibility that the intrinsic value may increase or decrease before the expiration date. As the underlying asset price will continue fluctuating during this period before expiration, there is a chance for the value of the option to rise (or fall). Time value decays with the passage of time. (Also note that the volatility of the underlying asset will help to determine the value of the option.)
One of the most important benefits of buying options is downside risk limitation. As presented above, buying a call or put option will cap your payoff to $0 and hence your maximum loss is the initial premium paid.
Options share a similar exposure to their underlying asset(s). How similar the exposure is depends on the option delta, where a delta of 1 reflects the same exposure. However, the initial capital required to purchase options is small. You only need to fork out the premium amount, which is usually much cheaper than buying the share itself.
If you’re expecting the price of a share to plummet, buying put options is one of the various ways to profit from the fall of a share price. Using derivatives such as options and CFDs is a good way to take an indirect short position in shares.
Short selling a share directly is expressly hard to do in Singapore due to various regulations (particularly but not only around borrowing said share). As such, using derivatives such as options and CFDs are a good way to take an indirect short position in shares.
Options are an efficient way to prevent big losses on your portfolios because of the first two benefits presented in this article: limited downside risk and low starting cash required. Let’s take a look at how options can act as a cheap method of safeguarding your portfolio.
For example:
In this scenario, you can buy put options on OCBC shares so that if the price falls, your payoff from the put options will offset the loss in value of your OCBC shares. Let’s say you buy put option contracts for 100 OCBC shares at a strike price of $10.
If the price falls to $8, your portfolio value decreases by $1000 - $800 = $200. However, your put option payoffs will give you $1000 - $800 = $200 as well. Of course, you must factor in the premium you paid as well, but you have essentially hedged the loss from your portfolio.
If the price had increased instead to $12, your portfolio value would have increased by $1200 - $1000 = $200. However, your payoff from the put options will simply be $0. So, the option contract does not affect your portfolio gains.
There are many types of options trading strategies. One of the more common ones you may encounter is the Covered Call. Covered Calls can be helpful in the following types of situations:
A Covered Call strategy involves having bought the underlying shares and selling (or writing) the options call contract, i.e. a long position in shares and short position in call options. If it turns out that the call option is ITM (market price > strike price), the buyer will exercise it, buying shares from you at the strike price. You will then use the shares that you already have to “cover” this call option, i.e. give them to the buyer of the option you wrote. Hence, the name. Unlike writing a "naked" call option, you no longer have unlimited downside risk if the shares shoot up, though, of course, you will miss out on owning them since you had to deliver them to the buyer of the option (i.e. you sold it to the buyer at the strike price).
In the case of buying options, your initial investment is the premium you paid to buy the option. Should you end up in an OTM position, your payoff will be zero, and hence your entire initial investment is lost.
Due to the presence of an expiry date, the value of options typically fall as time goes by. You can think of "time value" as how much time you are giving the underlying asset to potentially move by enough to change the intrinsic value of the option. You may see an option’s time decay by observing its Theta.
Options are generally available for shares, indices, commodities, ETFs, and even bonds. However, options are not available for all of them. Some shares do not have options tied to them, possibly due to the lack of demand or other market reasons.
Do remember that option trading can be very risky. Ensure that you are aware of all the risks before investing in them!
Option trading is not available on the Singapore Exchange (SGX) and as such, investors must look for brokers that have access to the US stock market or use the Singapore alternative called “structured warrants”.
Structured Warrants act similarly to options. They are available for a range of underlying assets such as shares and indices. These structured warrants are traded on the SGX and facilitated by market-makers who set the prices and make sure that investors can buy and sell the structured warrants with ease within the trading day. Taking a short position in these structured warrants are allowed intra-day; the positions will be forcibly closed at the end of the trading day.
Company Warrants are call warrants that are issued by companies themselves (with their shares being the underlying asset) to raise capital, instead of financial institutions. A market-maker may not exist for these company warrants. These can be traded on the SGX and are typically longer-dated.
Do remember that option trading can be very risky. Make sure that you are aware of all the risks before investing in them!
OPTIONS. COMPLETED. ✅
Sources:
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