Stock Option Trading – Escaping Volatility In Modern Equity Markets.
I believe that managers should always be financially aware, and not ignorant of the economy and financial markets. I hope this post will serve as a simple introduction to stock options trading, to help raise that ‘general’ finance knowledge that all leaders should be armed with.
Stock option trading in ‘Put’ options can be used to remove risk from owning shares, or to speculate upon it. It is simply a financial instrument that allows the transfer of risk from the risk-adverse investor, to a risk-tolerant investor.
What is a Stock Option?
A stock option is an agreement between two parties, that one will be obligated to buy or sell a stock at a fixed price, should the other party choose to enforce the right. The two parties are called the writer and the buyer. The writer is the party obligated to buy or sell the underlying stock at a pre-determined price, and the buyer is the party that receives the right to force the other party to do so, and will pay a premium for this extra power.
A ‘Call’ option gives a speculator the right to purchase a share at a fixed price, and provides the opportunity for profit if the market price of the stock increases. A ‘Put’ option gives a risk-adverse investor the right to sell their share at a fixed price, which will represent the maximum loss they can make. It is this option that can be used to reduce risk faced by equity-owning businesses, and the mechnics of which will be explained below.
An Example.
Lets say a shareholder of Apple Inc is holding 1 share worth $10. This investor will be worried that the share price could fall considerably, and would like to pay a premium in order to eliminate the risk of it falling below $8.
This investor will want to buy a ‘Put’ option agreement that will give them the right to sell the Apple stock at $8 in one years time. If as long as the investor holds this right, then their maximum loss within the year is $2 regardless of how badly the share performs in the market, because if the stock drops to $5 in value, then the investor will take up the right and sell to writer for $8 and make only a $2 loss.
As mentioned before, this is not a win-win agreement. The buyer of the option will need to pay a premium of $1 (for example) to the writer to compensate for the transfer of risk. This means that the buyer is opting to face a guaranteed expense in order to protect against a significant loss. It is effectively an insurance scheme.
The writer, who is accepting a guaranteed $1 income but facing the risk of making significant losses if the market crashes, is clearly betting the the price of the share will remain at its current level, or drop by only a small amount, and that the option will never need to be exercised.
Complexity
It will become clear that options are complicated instruments compared to simply owning shares, and thus a thorough knowledge is needed to be able to value the right of an options and give an edge to the trader. Companies such as Trading Concepts Inc offer options trading mentoring that seeks to first educate investors before they enter this potentially lucrative market. It’s always a good decision to become immersed in something before commiting your business to a particular strategy. So I’d recommend that if hearing about options has triggered an interest, then you do some research and learn more!
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