Do your homework before embarking on an options journey
- Some investors see options as a mystical tool, which they are not
- It pays to do research for options trades, as we do for an underlying security
- Find out what call, put, exercise (strike) price, premium and expiration mean
- Option trading is like a voyage of discovery
By Gary Delany
There is a lot of information available on using options as a hedging or investment tool. But sometimes it’s hard to see the forest for the trees.
It might be useful to offer some common sense comments on this theme.
I say this a lot in seminars. There is a tendency among some investors to see options as a mystical tool. They are not. In just the same way as you would do your research if you were investing in the underlying security, you need to do it for an option trade.
Is the security trading in a tight range? Is it about to spike, up or down? Are you concerned about the impact of a sharp down move on your portfolio?
2 How much do I know about options?
Of course the answer is ‘never enough’, but there are some core themes that you need to understand. Here’s a few of them.
- Basic mechanics: Do I understand the contract terms for an option trade – call, put, exercise (strike) price, premium, expiration etc? What is the right or obligation of the option buyer and the option seller? What does at, in, or out-of-the-money mean? Please see this site to learn more.
- Choosing a strategy: What are some of the typical strategies that market users are employing for hedging or investment? Do I know how to work out the profit and loss of my position for various price outcomes? What’s my upside, and my downside? What is my personal risk profile like? What level of risk – and cost – am I happy with? Make sure you understand the strategy and its profit and loss implications. See here for more information.
- Valuations: What ingredients influence an option’s price? What role is played by time to expiration, volatility, strike price, underlying price and interest rates.
own and see what strategies might be used with them. Photo: iStock
3 What if there are gaps in my knowledge?
Serious option investors will already be familiar with most of the above questions. If you don’t know any of the answers, help is readily at hand on The Options Industry Council website or the Trading Floor website.
4 Practice helps
5 Do I have a plan?
6 What practical choices do I have?
All investor profiles are different. One approach might be to start with the stocks that you already own and see what strategies might be used with them. For example, what happens if I write (sell) a call option on them?
And how can I buy cheaper protection if the market falls?
It’s been said 1,000 times, but options really do give investors options. Buying or selling calls. Or puts. Hedging or investing. A strategy involving just one option, or combined with another option, and/or an underlying security.
– Edited by Adam Courtenay and Robert Ryan
Gary Delany is European director of the Options Industry Council (OIC)