Options trading is a popular activity in Singapore, but there is still some confusion surrounding what exactly it is and how traders can participate in it. In this article, we break down what options trading really is, why it appeals to traders, and the elements in an options contract. Hopefully, you can make more informed trading decisions when you buy options in Singapore.
What is options trading?
Options trading is a type of financial derivative trading where the buyer of the options contract has the right, but not the obligation, to buy or sell an underlying asset (such as a stock, commodity, currency, or index) at a predetermined price on a predetermined date.
There are two main types of options that traders can buy: call options and put options. Call options give buyers the right to buy a predetermined number of an underlying asset. Conversely, put options give buyers the right to sell a predetermined number of an underlying asset.
A trader who buys a contract becomes the contract holder, while the trader who sells the options contract is a provider or the contract writer. Holders pay a small price, called a premium, for the option, and they can let the contract expire if they do not want to exercise it at its expiry date. Third parties can facilitate the exchange of options contracts, or transactions can take place peer-to-peer.
Benefits of trading options
The main benefit of trading options is that it can be a great way for traders to potentially make a profit, based on their predictions of where their market is going. But the same can be said for various forms of trading. The reason why options is such a popular product is due to the below:
Great flexibility
Options trading allows traders to tailor their positions to their specific investment goals and risk tolerance. Traders can find opportunities in both bullish and bearish markets as they can go long or short when purchasing an options contract. They can also find flexibility in how many contracts they want to purchase.
Use of leverage
Another advantage of trading options is the ability for traders to access and use leverage. Leverage is an amount of money borrowed to enhance the position size a trader opens. This affords them greater exposure to the market, which means the potential to increase the size of their profits substantially. However, leverage should be used with caution, because while traders can magnify their potential for profit, they can also incur catastrophic losses when the markets do not go as they predict.
Risk management
There are also people who use options contract as a form of risk management. For example, they may use an option as a hedge – if they have an existing position they do not want to close and they want to ride out momentarily volatile market conditions, they can purchase an options contract that goes the other way to offset their losses.
Another reason options trading makes a good risk management tool is because contract holders have the right, but not the obligation, to see their contract through and exercise their option. If they make a prediction based on where they think the market is going and their prediction is wrong, traders can simply let the contract expire worthlessly. This means they only incur the loss of the premium they paid for their contract, instead of losses from the whole position.
A variety of trading instruments
Finally, one big advantage of trading options is that traders can speculate on a wide range of trading instruments. The underlying asset in an options contract can be anything from stocks and indices to commodities and currency pairs. This gives traders lots of freedom to find the investment that is right for them, without having to physically exchange bulky products like barrels of crude oil or tonnes of industrial metals.
The anatomy of an options contract
If you are planning to trade options, you should make sure you understand what an options contract is and that you understand its elements when you buy or sell one. This can help you evaluate your transactions more accurately, which can help you identify and make the most of your trading opportunities.
Underlying asset
In every contract, there is such a thing as the ‘underlying asset’. This is the asset on which you wish to speculate, and you will be keeping an eye on how it performs in its respective market. For example, this can be a particular stock of a company, or it can be a currency pair.
Trading units
This represents the units – or the amount – of underlying asset the trader wants to buy or sell. Depending on the instrument, you may need to purchase multiple contracts to buy or sell the amount you want to. For example, in stock options trading, one contract may represent 100 shares of ABC Stock. If you want to open a position that covers 500 shares of the stock, you must purchase five contracts.
Strike price
This is the predetermined price agreed between contract writer and holder. It is the price at which the buyer of the option has the right to buy or sell the underlying asset. The strike price is fixed, and it cannot be changed by either party once the buyer buys the options contract.
Expiry date
This is the date on which the options contract expires. All options contracts have expiry dates, and depending on the style of the contract, traders can execute their trades only on (European style) or any time before (American style) the expiry date.
The expiry date also has an impact on the value of the contract, as the closer a contract is to an expiry date, the lower its value will be. This is called time decay, and it is a very important concept in options trading.
Type of option
There are two types of options contracts that traders can buy and sell. They are call and put options. A call option gives the contract holder the right to buy specific units of an underlying asset, while a put option does the opposite and gives the contract holder the right to sell specific units of an underlying asset. This is useful, as it allows traders to find opportunities in both bullish and bearish markets.
Premium
Finally, you should understand that traders buy an options contract with a small sum of money called the premium. It can be complex learning how options providers price their premiums, as it depends on a variety of factors such as time decay, the market price of the underlying asset, and more. If you buy a contract that you choose not to exercise when it reaches its expiry date, you can forfeit the contract and you will only lose the price of the premium.
The bottom line
Options trading can be an exciting endeavour for traders who want to find trading opportunities in both bullish and bearish markets, without a great deal of commitment. The accessibility of leverage also makes it very appealing to more advanced traders who wish to generate more substantial profits from their trades. However, it is important to remember that options trading cannot guarantee any profits, and traders should never expect a clear streak of winning trades. Rather, they should pay attention to how the markets move and how options trading works, so they can make the most informed decisions and minimise their risks when trading.
