Options are derivatives, which means they derive their value from the price of an underlying asset. The most common underlying assets used in options trading are stocks and indices.
Ordinary shares give shareholders the right to buy more shares at a fixed price on or before a specified date.
In return, you receive a premium from the buyer of your options contract.
If the option seller demands more for this derivative than vanilla options (i.e. those that derive their value from an underlying stock’s price movement), buyers would be better off buying shares directly.
There is no guarantee that they will be able to sell the derivatives at a higher price than they paid for it – after all, they can only do so if someone is willing to pay them more. So what are the benefits of trading listed options?
Option buyers have greater exposure to upside price movements without having to commit a large amount of capital. It is because option buyers’ exposure is limited to the premium paid for these derivatives, whereas buying shares exposes you to unlimited loss should the market continue going up.
Option sellers benefit from upfront premiums and do not need a lot of capital as a margin deposit. They are selling out their right to buy or sell at a specific price in return for an upfront payment. However, they have more exposure than share traders as options’ prices move essentially with underlying stocks’ prices.
In addition, option sellers may find themselves on the wrong side of the trade where options expire worthless after being written out-of-the-money (OTM). Control a large number of stocks for much less than it would cost to buy them).
A protective measure against market risks
Holding onto both long and short positions of options is considered risky because if prices move contrary to your expectations, you will incur substantial financial losses. Therefore, people tend to trade options as a means to hedge their positions.
For example, say you have a long position of many stocks trading at HK$30 each, and the market takes a turn for the worse where you can only sell all stocks at HK$20.
In this case, your losses would be huge if you do not buy put options on these shares to protect yourself from further declines in prices because there is a chance that prices could drop even further beyond your expectations.
Maintain long positions in stocks they like
Options traders who hold onto both long and short positions of options can profit from price movements in both directions (upwards or downwards).
For instance, if they buy a call option on a stock they like when it is priced at $10 but see its value increasing to $15 by expiration, they have gained $500.
They also benefit from holding onto the underlying asset while receiving dividends along the way—a nice little bonus! If the option expires OTM, it will expire worthlessly, and they will only lose the $50 premium they paid for it.
Have control of many stocks for much less than buying them outright
Options traders who hold onto both long and short positions of options can trade thousands of stocks at a fraction of what it would cost to buy them outright.
Reduce volatility of a portfolio
Options traders who hold onto both long and short positions of options have the opportunity to reduce volatility on their portfolios, as they can benefit from price movements going either way. If you are holding many shares that you bought at different prices, it makes sense to hedge some of those shares by writing puts or calls on them to avoid big swings in value due to general market fluctuations.
In this way, option trades allow investors to tailor their strategies according to changing market conditions, resulting in higher returns with less risk. You can also sell covered calls against your holdings if that particular stock does not perform well, but you expect its price may go up over time.
Next you can familiarize yourself with vanilla options.