Mention Option trading to seasoned investors and you'll get the
same reaction you get from a plumber when he's about to quote you a
price! A shake of the head and a sharp intake of breath is the
normal reaction when a retail investor enquires about option
markets. This is because many believe these are complex and
advanced products that are more suited to the professional and
institutional market place. In some cases this is true, but as with
any financial product if the market and product is researched the
risks can be understood and more importantly reduced.
The definition of an Option, as quoted on Wikapedia, is a
contract between two parties concerning the buying or selling of an
asset at a reference price. The buyer of the option gains the
right, but not the obligation, to engage in some specific
transaction on the asset, while the seller incurs the obligation to
fulfill the transaction if so requested by the buyer.
In practice the concept of option trading is simpler than it
first appears. Let's look at an example using the gold market and
better understand how options actually work.
If gold is trading at a price of $1400 and Trading.co.uk wants
to hedge exposure to the price of gold moving above a price of
$1450 it may wish to take out an option to buy Gold if the price
rises above this level. This 'reference price' or 'strike price' of
the option is the level that both the buyer of the option
(Trading.co.uk) and the seller of the option (the Market Maker)
agree to form part of the contract. The seller of the option
requires the buyer to pay a premium for the hedge (or think of it
as insurance) and so sets a level of the premium that both the
buyer and seller are happy with.
In this example let's suppose the seller and the buyer agree on
a $5 premium which means that the buyer won't begin to make money
from the trade until the price rises above $1455 and the seller
won't begin to lose money if the price doesn't rise above this
level. Clearly the seller of the option has unlimited risk. If the
price of Gold rises to $1550 he is liable for every dollar move
above $1455 so would be faced with a loss of $95 times the buyers
chosen stake. If the price of gold never reaches the strike price
of $1450 the buyer loses the whole premium paid ($5 in this
example) but he cannot lose more than the premium paid.
In short, buyers of options have limited downside and unlimited
upside, for sellers the reverse is true.
So what's the appeal of being an option seller? Unlimited
downside and limited upside doesn't sound like a great deal. That
is until you read that most options expire worthless and that
historically it is the sellers of options who make money. It's a
bit like an insurance company collecting premium from householders
to insure their personal effects. Most individuals will never claim
on their insurance policies but like to know that if the worst
happened they are covered. Occasionally something terrible happens
in a part of the world that means insurance companies have to pay
out hundreds of millions of pounds in claims. Often they have
re-insured some of their risk with other firms so that they are
able to settle every claim in full.
Go back to 2008 when the markets went into meltdown during the
banking crisis and as an option seller you would experience
something akin to the catastrophe insurance claims described
above. The markets went into free fall and so all of the
option buyers who were insuring against the market falling would be
very quickly in profit. Selling options can sound like a good idea
but understanding how quickly things can move against you is
incredibly important and ensuring you have enough capital to
undertake such activity is obviously a definite requirement.