This year I have decided to try using options to generate a new source of income. I have been learning as much as I can about options trading and I have also tried my hand in some simple trades. I will try to summarise what I have learned so far, and in the next post, will give a summary of some of the trades I have attempted and what I have learned.
I will not go into the details of what is options trading here, there are many online resources that are available that can explain much better than I can. Just a couple useful ones that I benefitted from greatly can be found below:
Options Trading for Beginners (Investopedia) - https://www.investopedia.com/articles/active-trading/040915/guide-option-trading-strategies-beginners.asp
Options Trading in Singapore (Dr Wealth) - https://www.drwealth.com/options-trading-singapore/
For an even more detailed and comprehensive overview of options trading, you can also read
Essential Options Trading Guide (investopedia) - https://www.investopedia.com/options-basics-tutorial-4583012
Instead, what I will try to do is to distil what I have learned so far and try to summarise a few of the key strategies that I think makes sense as a beginner in options trading. This exercise is really meant as a way for me to document my learning journey into the exciting world of options trading.
While I won’t go into details, it is still worth giving a recap of my understanding of options. Options in essence is an agreement to buy or sell a certain underlying stock at an agreed price (Called the strike price) by a certain date which is the expiry of the option. In exchange for this agreement, a fee known as the premium is paid. As with all agreements, there are 2 parties. One party buys the option and pays the premium. The seller of the option thus collects the premium and promises to fulfil the option if the buyer chooses to exercise the option. The buyer will of course only exercise the option if it makes financial sense to do so.
There are 2 main types of options – a call option and a put option. A call option is an agreement to buy or sell a stock at a certain price at some future date, no matter what the market price is at the time. A put option is an agreement to sell a stock at a certain price at some future date, no matter what the market price is at the time. One analogy that I learned which I thought makes a lot of sense is that buying a call option is like putting down a deposit and locking in the price – say putting down a deposit for a wedding venue. In exchange the venue operator will not be able to increase the price on me nor will he be able to rent out the venue to anyone else, even if the other client is willing to pay more. Similarly, buying a put option is like buying insurance. So if something bad happens, like the stock price crashes, the put option allows me to sell the stocks at the agreed price even if the stock has crashed to a much lower value. And just as with any other insurance, I will have to pay a premium for this safety net. These analogies actually really helped me understand the concept of options.
So, if you think a stock will increase in price in the future, you would buy a call option. These options will increase in value as the price of the stock increases, and allows me to buy the stock at the lower strike price and then sell these stocks at the higher market price for a profit. Conversely, if you believe the stock will go down in price, then you can buy a put option as a safeguard to protect your investment value. One key thing to note is that these options will increase in value as well as the stock price moves. Another important characteristic of options is that it is time-limited by the expiry date, thus time to expiry becomes another variable in determining the option price. In many cases, we do not need to exercise the option itself, but can make a nice profit by just selling the option at a price above what we paid for it. There are of course many many other nuances and strategies, which I will try to distill in subsequent posts.
In simple terms, I see it in the following way:
1. Buy Call – Multiply returns from growth stocks through increasing prices
2. Sell Call – Generate cash flow from stable stocks
3. Buy Put – Protect against unexpected drop in share prices of stocks you own.
4. Sell Put – Generate cash flow while waiting to buy stocks you want to own.
I have put together a simple 2×2 matrix which I have always found to be an excellent framework to organise information.
Some final key takeaways about options which I think are very important:
1. In general, I am long term bullish of the stock market. Don’t bet against the market.
2. Only buy or sell options of high quality stocks that you believe in.
3. When buying options, have a longer expiry with more time to benefit from it.
4. When selling options, have a shorter expiry with less time to be liable.
5. Selling options can be a means to generate cash flow.
6. Buying options can be a form of leverage to multiple benefits with limited downside risks.
Finally, I am just a beginner in options. The information I write here is my understanding, and I may very well be wrong. So I would appreciate any feedback or comments as well to help me in this journey.
If you'd like, you can also follow my brand new blog at https://spoilt4options.wordpress.com/
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