Options are traded in the options market. Option is a term synonymous with the finance department that gives one (buyer/owner) the mandate to buy or sell a commodity as per the agreed price, but within a given period. The “right or obligation to buy or sell is manifested within the seller who exercises it in order to fulfill the transaction” (William 15). An option that gives the owner the right to sell an instrument or an asset is known as a ‘put option,’ while an option that gives the owner the right to buy an instrument or an asset is known as a ‘call option’ (Hull 27). In the stock market, both options are commonly traded. Examples of options traded include; equity options, bond options, over the counter options, commodity options, and the currency options. There are certain styles that are used to distinguish between properties of different options that are traded in different markets. For instance, a European option is an option that is only traded or exercised after the expiry of the specified date. On the contrary, an Asian option determines the price (payoff price) by finding the mean price calculated over a given period.
Protecting a ‘short position’ with options
In the options market, the owner or the buyer of an asset or instrument is said to be having a ‘long position.’ While the ‘writer’ or seller of the option, in this case being an underlying asset or instrument is said to be having a ‘short position’ (William 14). A trader will always want to be protected from ‘short position’ or short-term occurrences or happenings in the stock market. For such to happen, the following strategies are adopted.
First, the protective purchase of options is adopted. This involves purchasing the ‘puts’ or ‘calls’ in proportions. This is based on the stock, whether ‘long’ or ‘short’ stock. A ‘short position’ will be protected in the sense that the position will be turned into either a ‘put’ or a ‘call’ within its life. Second, the ‘writers’ should be covered. These ‘writers’ will allow a trader to sell options, thus having the ability to generate cash and enjoy protection from short-term happenings. It is important to note that a trader is only protected up to the price of the ‘call.’ This means that if the price of the stock declines or moves down, a trader will have protection against losses and will receive protection against the ‘call’s’ price. If the price of the ‘call’ moves upwards, the trader will not make substantial profits but will be limited in terms of profits made. This strategy, therefore, offers protection of ‘calls’ on the lower side. Third, the ‘short put’ strategy should be adopted. This happens when a trader wants to purchase stocks only when the price is down. A trader could put a limit order. But the best way is to ‘short a put’ at price or strike where the trader wants to buy the stock. This means that if the price of the stock moves towards this strike, the trader will purchase the stock. When the price of the stock doesn’t move towards the ‘short a put’ strike, the ‘put’ will be considered to have expired and the trader will make profits from the price of the expired ‘put.’ This strategy is different from that of protective purchase. It is dependent on the trader’s opinion of buying the stock at a certain specified price. Finally, the ‘collar’ strategy should be adopted, an approach that combines both protective purchase of options and the covered ‘writers.’ A ‘collar’ is similar to a fence, meaning that a trader has set limits on both profits and losses in order to receive protection from ‘short position’ (Scholes 640).
The way leverage works in purchasing ‘call’ options
When trading in options, leverage simply means borrowing funds in order to purchase instruments. Leverage is important in that it can be used to turn a smaller amount of invested capital into substantial gains or profits. In trading options, the contracts serve as a leverage tool to the traders, meaning that traders are given the ability to multiply their initial invested capital largely. Leverage factor allows traders to make higher profits. It should also be noted that the higher the leverage, the higher is the profits or the losses.
If a trader wants to purchase the ‘calls’ of ABC Company, which trades at $20 and with a strike price of $200 and a contract size of 1000. The investor will purchase 50 contracts at $2000 each. This means that this trader will have control of 5000 shares of ABC Company, resulting in 50 contracts each covering 100 shares. This means that with leverage the trader has been able to purchase ten times as much ‘call’ options as the shares of ABC Company; this is if shares were bought directly and the initial investment was $10,000. This means that through sale options, the trader will make higher profits.
This illustration indicates how leverage works in purchasing options. The principle of options in leverage simply means that a smaller amount of initial capital is used to make substantial profits. Unlike in trading “other financial instruments, trading in options offers a huge advantage while using leverage” (William 42).
Hull, John. Options, Futures and Other Derivatives. London: Oxford University Press, 2005. Print.
Scholes, Myron. “The Pricing of Options and Corporate Liabilities.”Journal of Political Economy 81.3 (2010): 637–654. Print.
William, Lasher. Practical Financial Management. New York: St. Martin’s, 2011. Print.