Stocks not cutting it for you? Looking for an investment vehicle that can make you quicker cash than the boring ol’ STI ETF?
Then you might be considering something called “options trading”, perhaps inspired by tip-offs from friends-of-friends who’ve been raking it in and are now taking a long sabbatical from work thanks to their winnings.
Is options trading something you too can profit from without risking your life savings? Let’s find out.
What is options trading?
Options are contracts which enable you to buy or sell an underlying asset if certain conditions relating to price and timeframe are fulfilled.
Instead of buying an actual financial asset, you are only buying a contract giving you the right to buy or sell the asset. Hence, “options”.
Stocks are the most common underlying assets for options, but you can also buy or sell options for indices, ETFs, bonds and commodities.
When you buy or sell options, you are dealing with one of the following:
- A call option enables you to buy the underlying financial asset.
- A put option, on the other hand lets you sell the asset.
The option will also indicate the price at which you must buy and sell the asset, as well as the expiry date by which you must exercise the option and effect the purchase or sale.
How is options trading different from stock trading?
When you buy stocks, you are buying an actual financial asset — i.e. a share in a company.
Options, on the other hand, are just derivatives or contracts based on an underlying asset’s value. While an option gives you the right to buy or sell the asset, it does not force you to do so.
Feeling lost? Here’s an example of a real life “option” that might be closer to home: the Option to Purchase (OTP) when purchasing an HDB resale flat.
The OTP is a legal contract that gives you the right to buy the resale flat at a certain agreed-upon price. It’s not a contractual obligation to buy the flat. Nor does it say that you now own the flat (which is the underlying asset in this case).
However, it does come with a fee. Let’s say you pay $5,000 for the OTP for the HDB flat of your dreams. You and the seller agreed on a sale price of $500,000.
What might happen next?
Imagine if the seller made a huge mistake and grossly underestimated the value of their home.the Turns out it’s one of the most desirable resale flats in the land and is worth $1 million! But because he already sold you the OTP for $500,000, you have the right to purchase it at the very discounted price. You can profit, at least in theory.
On the other hand, it might turn out that the flat is haunted and you decide not to buy it after all. You don’t exercise your OTP. You lose the $5,000 option fee.
What are some options trading strategies?
When you trade options, you are betting on the price movement of the underlying asset.
Let’s say you think the price of a stock will rise. You will then buy a call option, which enables you to buy the stock by a certain expiry date at a pre-defined price, also known as the strike price.
If the price of the stock rises above the strike price before the expiry date, you make a profit, as you will have the right to buy the stock for less than what it is worth.
Now, what if you think the price of the stock is going to fall? In that case, you buy a put option, which acts like insurance against a falling investment. The put option gives you the right to sell the stock by a certain expiry date at the strike price.
If the price of the stock falls below the strike price before the expiry date, you make a profit, as you have the right to sell the stock for more than it is worth.
As you can see, to profit from options, stock prices have to cross a certain threshold before a given expiry date. But what if they don’t? In that case, you don’t exercise the option, and your loss will be the price, or “premium”, that you paid for the option.
You can also sell call and put options on stocks that you own. When you sell an option, you are forced to buy the underlying stock at the strike price if the buyer exercises the option. So, you want to bet against the price movements that the option buyers are hoping for.
Thus, you sell a call option if you think a stock’s price will stay below the strike price, and you sell a put option if you don’t think the price will fall below the strike price. If the buyer is unable to exercise the option, your profit will be the premium the buyer paid you.
What are the risks of options trading?
Options trading is much riskier than stock trading as it is a zero-sum game.
When you buy call or put options, you risk losing 100% of the money you put down. In a worst case scenario where you are not able to exercise any of your options, you lose all the money you have paid as premiums.
Going back to the property example, just imagine if you snapped up the Option to Purchase at $5,000 — only to realise you don’t have enough money to make the flat purchase. So you end up losing $5,000 with nothing to show for it.
When it comes to selling call or put options, if the buyer exercises the option you will be forced to sell your stocks. When you sell a call option, the risk is unlimited, while the risk for sellers of put options is the value of your stocks.
Is options trading suitable for beginners?
Options trading is a relatively complicated derivative to understand and trade, so if you just signed up for your very first broker, please, we beg you, for the love of your favourite god/deity, stay far away!
For experienced traders, options can be used as “insurance”, that is, to hedge against risks in your portfolio. If you don’t monitor your stocks closely, you can opt for options with longer expiry dates.
Which brokerages offer options trading in Singapore?
Options trading is not available on the Singapore stock exchange (SGX). So options traders here usually use online brokers that offer access to US markets.
Some brokers you can use include local ones like PhillipCapital (POEMS), OCBC Securities and UOB Kay Hian, as well as international platforms like Saxo Markets, TD Ameritrade and IG.
Not sure which broker to go with? Browse and compare online brokerages that let you trade on US markets here.
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