How profitable is options trading 1
Trading options - a guide for a profitable start
Author: Pit Wilkens - content checked by: Philipp-Malte Lingnau
Options are among the most flexible financial instruments and can also be used successfully by private investors. However, trading options successfully requires basic knowledge of their structure and function. The content of this article is all about the first steps in options trading.
What are options?
Options belong to the security category of Derivatives. It is a financial product that is derived from an underlying asset (e.g. a share). Options have an exercise price (strike price). The underlying can be bought or sold at this price. Only the buyer of an option has this right. He can exercise an option, depending on the type, during the entire term or on the expiry date. He pays the seller an option premium for this right.
The seller of an option acts as the writer. He can only wait for the price development of the underlying until the end of the term or close out his position beforehand. The buyer of the option can - but does not have to - become active by exercising the option. Because the option right does not have to be claimed, options are listed as conditional futures contracts designated.
What types of options are there?
Options can be divided into calls and puts. A call option certifies the right to buy the underlying asset. In contrast, a put option enables the underlying asset to be sold at the strike price. Buying options is also known as a long position. On the other hand, options sell as short.
Due to the two types of options and positions, four basic combinations are possible. These are long call and short call or long put and short put.
The table below shows how the respective combinations react to changes in the price of the underlying.
|Long||benefits from rising prices||benefits from falling prices|
|Short||benefits from falling prices||benefits from rising prices|
What are the requirements to trade options?
The basic requirement for trading options is as simple as it is essential. A budding options trader needs a bank or one Brokergiving him access to a Futures exchange procured to trade options. In Germany this futures exchange is called Eurex and is also the third largest in the world. There are also various trading centers in the USA. The combination of trading venue and broker / bank determines, among other things, which one fees the options trader has to bear. The lower the fees, the higher the potential profit.
Where can options be traded?
Standardized options contracts can be traded on various futures exchanges around the world. The best-known trading venues include Eurex (Europe) and CME (USA). Futures exchanges basically function like exchanges for other securities such as stocks. The main difference is that only futures contracts such as futures and options are traded on these exchanges. The futures exchanges also guarantee the execution of the Orders.
All options that are listed there can be traded on the futures exchanges. In addition, different trading venues can have different trading hours. Options can be traded on Eurex from 9:00 a.m. to 7:00 p.m. Euronext Netherlands also opens trading at 9 a.m., but closes it at 5.30 p.m.
Options trade outside of the exchange
Options that are not traded on a futures exchange are also called "OTC options". OTC stands for over the counter. In OTC trading, no futures exchange is used for business transactions. In addition, the traded options no longer have to adhere to the standardizations already mentioned. Options traders can consequently trade contracts that are not tradable on the futures exchanges. Still, from this circumstance Riskssuch as a counterparty risk or a lack of market liquidity.
Note: Time differences may have to be taken into account in the trading hours. American trading centers, for example, open in the afternoon (European time) and therefore close at night.
Which brokers are suitable for trading options?
When choosing a broker, there are some objective points that should be kept in mind. These include, for example
- the regulation,
- the costs,
- the trading platform
- as well as the available trading venues.
One of the basic factors for a reputable broker is his Licensing. For example, if a broker is active in Germany, they should also have a German license from the financial supervisory authority (s).
For active traders in particular, the costs of a broker can negatively affect returns. Lower costs, such as order fees, can therefore have a positive effect on the Return impact. Therefore, brokers for the shortlist are conceivable who act professionally but do not exceed a certain budget. In addition to the order fees, possible costs that have to be taken into account include, for example, commissions or fees for changing orders. The detailed cost information of a broker can be found in the respective list of prices and services.
In addition to these aspects, a professional trading platform for options trading is necessary. Usually, German brokers provide the trader with a trading platform. One of the most common trading platforms is the Trader's workstation (short: TWS). This trading platform can, for example, be flexibly adapted to the needs of the trader. More on this in the following video:
Ultimately, a suitable broker for options trading must map all the necessary trading venues. Otherwise, it would be necessary to choose a second broker, which would mean additional administrative work.
In addition to these factors, the retailer's personal needs with regard to support or user interface can also be taken into account.
Account size when trading options
A recommendation for the optimal account size in options trading is not possible. However, it is important during the build-up phase of a depot that it is capable of acting and that it can cope with initial losses. Even with a solid trading strategy, temporary losses can be possible. In such a phase, the deposit value should still be high enough that further trades remain possible.
It can therefore be helpful to deposit a little money first. What "little" means in each individual case depends on the financial situation of the option trader. However, significantly less than 5,000 euros should not be paid in at the beginning, so that both a certain cushion and enough room for maneuver are available.
Trade options with the right strategy
In addition to basic knowledge of the financial markets and the “option” product, a strategy is crucial for success and failure. The choice of an option strategy decides in advance which options (call or put) will be bought or sold (long or short).
A successful option strategy can also include self-defined framework conditions that the option trader would also like to adhere to. If, for example, certain profit or loss thresholds have been reached or previously defined events occur (e.g. price increase of 5%), the option strategy can be used to define how this should be dealt with.
In this context, trading options can also require learning a certain “mental strength”. The options trader should not only reject the rules he has set himself, but should also be able to act accordingly if the strategy is implemented in practice. If, for example, the loss of a position is so high that the previously defined strategy would provide for the sale, this should then also be implemented in practice.
If a strategy or parts of it do not make sense, these can be adjusted by the options trader at any time.
What should be considered when trading options?
Basically, when it comes to trading options, the product traded must match the previously defined option strategy. In addition, the retailer should understand the product and be aware of the opportunities and risks. In addition to these basic factors, there are other things to consider when choosing an option. These are explained below:
The underlying value of an option or its price significantly determine the value development of the position. For example, stocks, indices or ETFs can be used as the base value. In order to be able to assess the underlying, the options trader should have analyzed the respective security.
Depending on the desired option strategy, volatility, the underlying or other key figures and factors can play a role. This should be taken into account by the options trader in order to obtain the correct option on the correct underlying to act.
When trading options, the options trader can choose between a call option or a put option. The basis for the selection of the option type are the market opinion and the strategy of the trader.
In some trading strategies, call and put options are also combined in several “legs”. It is therefore not necessary to specify a single type of option.
In addition to the type of option, a distinction can be made between two positions. These are the long and short positions. If a trader writes an option and acts as writer, he takes a short position. In a long position, the trader buys an option and can decide whether to exercise it.
Note: The type of option (call / put) and positioning (long / short) are the basis of the high flexibility of options. At the same time, they are important factors in choosing "the right" option.
Number of contracts
The strike of an option, its subscription ratio and the available liquidity affect the number of contracts traded. With identical capital, significantly more options contracts can be traded on an underlying asset such as E.ON than on Apple, for example. In the case of small depots, some underlyings cannot be realized at all. An options trader can therefore decide initially how many options contracts are to be traded and the size of the portfolio.
Note: The number of contracts should also be taken into account when it comes to utilizing the margin. This broker's credit should not be fully used, so that there is room for unexpected market movements.
The term, or the remaining term, of an option depends on the option strategy and can vary widely. Options can be traded with a term of just a few days or with a term of several months. The rewards, expectations, and uses of these various options also differ. The duration can play an important role, especially for strategies that consist of several individual options. For example, if all traded options are to expire on the same day, special attention must be paid to this fact.
Options can be traded in both American and European styles. However, the form of exercise differs for these two types of options. American options can be exercised during their entire term. On the other hand, this is at European options only possible on the expiry date. If a trader orients his strategy, for example, to exercise an option early, he must choose an underlying asset on which American options are traded.
Note: Although American options can be exercised during the entire term, this rarely happens in practice. Often times it makes more sense to sell an American option than to exercise it early, as exercising the remaining fair value would be lost.
In options trading, a distinction is made between physical delivery of the underlying asset and cash settlement. For example, in physical delivery, a share actually changes hands when the option is exercised. In the case of cash settlement, only the monetary value of the option is transferred. Since there are option strategies that rely on the physical delivery of the underlying or consciously want to avoid it, it is also a point that can be taken into account when choosing an option.
Trade options with real-time prices
Most options brokers offer real-time prices for the common futures exchanges for a small fee. For an options trader, these can mean advantages. If this offer is no longer required, it can often be canceled at very short notice.
Why trade options? - 3 important reasons
There are several reasons that it can make sense to trade options. One argument can be the flexibility of options. Income can be generated with options in any market situation. In addition, it may also be the desire to secure the portfolio with it or the intention to build up a passive income through options trading in order to gain financial freedom.
1. Strategies for every market situation
With options, strategies are possible in every market situation that can lead to a profit. The options trader can bet on rising, falling or constant prices. Even the change in volatility (the fluctuations in prices) can be used with the right strategy.
Benefit from rising prices with a long call
One strategy for expecting rising prices is, for example, the long call. A long call consists of buying a call option. The strike is often chosen to be slightly below the current price. If the price of the underlying rises, the options trader can realize a profit.
Bet on falling prices with a long put
In contrast to the long call, the long put offers an opportunity to generate profits when prices are falling. To do this, the options trader buys a put option. The strike is usually chosen so that the trader's expected target price is below the strike. If the underlying falls below this threshold, this means a profit for the holder of the option.
Take advantage of sideways trends with options
Strategies that benefit from a neutral price development are sometimes more complex than the two previous examples. With a so-called "Condor", the options trader realizes a profit, for example, if the price of the underlying asset on the expiry date is hardly any different from when the position was opened. The following graphic shows the structure of a "Long Call Condor Spread".
2. Secure your portfolio with options
In addition to strategies with which a profit is to be achieved, options can also serve to hedge existing positions. This procedure is also known as hedging.
The protective put is an example of a hedging strategy. The basic requirement is the possession of the underlying asset. To do this, the investor buys a put option that relates to the identical underlying. If the price of the underlying asset falls, the price of the option increases in return. The option therefore acts as an insurance against exchange rate losses. However, if the exchange rate remains constant or increases, the option premium paid is lost.
3. Passive income with options
The term passive income expresses that little or no effort is required to generate an income stream. A distinction must be made between this and active income, for example from an employment relationship. Active income arises from actual work - passive income, on the other hand, arises from capital working.
Options can be used in conjunction with so-called Silence strategies also lead to passive income. A writer strategy, also called writer deal, is based on writing an option. The options trader thus acts as a Writer on. The main task during the term is to monitor the positions. Otherwise, time works for the options trader.
Every day that the price of the underlying does not reach the strike of the option, the time value of the option falls. This has a positive effect for the writer. At best, the option expires worthless at the end of the term. In this way, the option writer can collect the premium without incurring any further obligations from the option.
An example of such a strategy is the covered put, also known as a cash-secured put. A put option is sold for this strategy. However, the options trader always holds sufficient funds to buy the underlying asset if the option is exercised by the buyer. The maximum profit arises when the option expires worthless.
Trading a Call Option - Example
An options trader expects a stock's price to rise.This is currently quoted at a rate of 30 euros. In order to benefit from a positive development of the share with little equity investment, the trader buys a call option on the respective share. The dealer chooses the strike at 30 euros. If the price of the underlying rises, the option is consequently “in the money” and develops positively for the options trader.
If prices fall or remain the same, the options trader only loses the premium paid. This constellation is similar to an insurance that is ultimately not used by the policyholder.
Trading a Put Option - Example
Another investor has analyzed the same stock in depth. He comes to the conclusion that it is already slightly undervalued at a price of 30 euros. At a price of 28 euros, the trader would be ready to buy the share.
Therefore, the options trader sells a put option with a strike of 28 euros. If the share is below a price of EUR 28 on the expiry date of the option, it will be exercised. Even if the price falls to, for example, 25 euros, the writer has to buy the share at a price of 28 euros each. However, since he assumes that the share is already significantly undervalued at 28 euros, the trader accepts this possibility.
If the price of the underlying does not fall below EUR 28, the option expires worthless. In this case, the investor can withhold the option premium received. However, he does not acquire the share.
Common questions about trading options
A prospective options trader needs a bank or broker who gives him access to a futures exchange (such as Eurex) in order to trade options. He then places a buy or sell order on the trading platform. If the process is successful, a transaction fee is usually charged for this.
How does an option work?
An option is a conditional forward deal in which one market participant acts as a buyer and another as a seller. Depending on the type, options certify the right to buy (call) or sell (put) an underlying asset at a fixed price (strike) and in the future.
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