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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. No matter how out of the money your option becomes, i.e. share price falls when you own a share call option, your losses will be capped (at 100%, or a total loss, but this is the trade you take for potential unlimited upside!)
Options share a similar exposure to its underlying asset(s). How similar the exposure 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. Generated returns can be similar to having the share, despite a much lower initial outlay of cash. This does amplify your profits (seen as a percentage of your initial investment), but the reverse is also true.
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 are a good way to take an indirect short position in shares.
Note - Short selling a share directly is expressly hard to do in Singapore due to various regulations (particularly but not only around borrowing said share).
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.
Things get much more complicated when you continuously hedge asset exposure since the delta (also known as the hedge ratio) changes with the share price movement. This is known as delta hedging, but this is (fortunately!) usually the realm of professional traders.
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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).
The payoff when the call option is ITM is thus 0 because the losses from your short call offset your gains from the shares. However, if the call option is OTM (market price < strike price), the buyer will not exercise it, and your payoff for the short call will be 0.
Your total payoff will then be the share payoff (market price minus price purchased at). Your profits from this Covered Call strategy will add the premium received from shorting the call option and minus the total spent on buying the underlying shares.
Graphically, this is how you expect your payoffs and profits per pair of shares and option to look. We will use the same example as above: the call option premium is $0.80 per share, with a strike price of $5, and let’s assume that you bought the share at $4.50.
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. Let’s compare this to a share.
Scenario: The current share price is $5, but it will have fallen to $4 at the end of the month.
A call option bought with a strike price of $5 and a premium of $1.50 would, at the end of the month, have lost $1.50. 100% of your entire investment of $1.50 is lost.
If you had bought the share itself at $5 initially, at the end of the month, you would have a loss of $1. $1 is only 20% of the investment of $5 you initially put in. As long as the company stays afloat, there is always a chance of regaining the loss.
This 20% drop is a REAL loss, though it is "unrealised" because you have not sold the shares, it is sometimes known as a "paper loss", but don't be fooled into thinking it is anything other than a real loss.
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!
THE BENEFITS OF OPTIONS. COMPLETED. ✅
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