Episode 2: How Options Trading Works (Using Travel Insurance Plan As Analogy)
While getting ready for our holiday, we would usually buy a travel insurance for a peace of mind. In doing so, we pay a premium (fees) to the insurance company to cover us for the period of our holiday.
Whether there is a claim or not, the insurance gets to keep the premium that is paid upfront to them.
If something happens, the insurance company will compensate with a payout.
In an option contract, there is also a set of buyer and seller and the concept is similar to buying an insurance policy. The buyer of the option contract is the customer while the seller is the insurance company. The terms of contract largely depends on the share price upon expiry date of the contract.
Depending on the nature of the contract which dictates whether the payout happens if market price of the shares falls below or rises above the agreed shares price when the contract expires, the seller will have to either sell away his shares or buy new shares as the payout.
So, there are a few terms that are important to note in an option contract and they are:
- Strike price: the agreed share price for the option
- Type of option (call/ put): To explain below
- Expiration date: the date that the option contract expires
There are only 2 types of options: they are put option and call option.
In a
put option contract, the
seller will have to
buy 100 units of shares from the buyer if the
market price of the share falls below the agreed price on the
date that the contract expires. If the closing market price of the share is
above the agreed price, then the seller
do not need to buy any shares from the buyer of the option contract. He will keep the premium without needing to do anything.
Example: Helen (Seller), Ivan (Buyer)
Name of share: Apple
Strike price: $140
Type of Option: Put
Expiration date: 12 Nov 21
Premium: $7
In this example, Helen agreed to buy
100 shares of Apple stock at $140 each if the market price of Apple is lower than $140 on
12 November 21 and
collected $700 ($7 x 100 shares as each option contract is 100 shares) from Ivan.
In order to be the seller of this option contract, Helen needs to prepare $14,000 just in case she has to buy the shares from Ivan on expiration date. This type of option trading is also known as “cash secured put” or “cash covered put”.
So, on 12 November 21, if market price of Apple is higher than $140, say it closes at $141, Helen will not require to buy 100 shares of Apple from Ivan. She gets to keep the premium and the $14,000 set aside previously. She can now participate in another option contract.
Option Buyer & Seller Mentality
For a Put option buyer, he generally believes that share price will drop below agreed price so he is willing to pay a premium to make sure he gets to sell his shares at that agreed price just in case his share price dropped drastically. In the example above, if Apple shares drop to $40 on 12 November 21, Ivan will still be able to sell his 100 Apple shares to Helen at $140, instead of $40, thus saving himself a $10,000 loss [($140 – $40) x 100] from this catastrophic price crash. To protect himself from a potential huge loss ($10,000), he is willing to pay a premium ($700) for the insurance policy aka option contract.
For a Put option seller, she generally believes that the share price will rise above agreed price of the contract or she is willing to pay the agreed price to own the shares and be given further discount from the premium she has collected. In the above case, Helen thinks that Apple shares at $140 is a bargain and does not mind paying $14,000 to own 100 Apple shares as part of the option contract (if exercised). Furthermore, with the premium she has collected, Helen final share price of owning Apple is $133 ($140 – $7 premium).
I hope this article gives you a easy understanding of how options trading works. I will leave the explanation of the 2nd type of option (call option) in another post to give you some time to digest this concept first.
Option trading, in my opinion, is a powerful strategy that can help you generate good returns and possibly build a sideline income, if you know how to do it right. The risk can be managed if we use options on companies with good fundamentals and strong cash positions. These companies include the technological giants such as Apple, Microsoft, Facebook or Alphabet (Google) and semiconductor powerhouses such as AMD or Nvidia. While these companies generally give a lower premium than the more volatile stocks such as AMC or Gamestop, they compensate by giving options traders less risk through price stability.
