When it comes to speculation or hedging, options are capital-efficient tools that provide leveraged exposure in the markets, allowing traders to capitalize on their market opinions at a low cost.
An option contract is a derivative of an underlying asset; it is an insurance contract that represents the right to buy or sell an asset, at a later date and agreed upon price.
An option, though it can be used to speculate, is a hedging instrument.
Option buyers purchase an option to insure against losses on an underlying they are long or short in. In other words, if an individual was short stock, they would buy a call to hedge risk to the upside (i.e., as the stock rises, the call rises in value). Or, if an individual was long stock, they would buy a put to hedge risk to the downside (i.e., as the stock falls, the put rises in value).
Option sellers write options in exchange for premiums derived from pricing formulas that take into account the following:
As most people have realized, nothing in the world is free. When it comes to insurance, money is made through the calculation of expected probabilities and writing of overpriced policies.
Actuaries assess the information provided by prospects and derive expected values.
For example, assume that it is determined that there is a 0.25% chance an insurance company will have to pay out $10,000. At the same time, there is a 99.75% chance a payout will not be made. Based on this information, the company derives a fair expected policy value of -$25. For the insurance company to make any money, it will have to charge a premium that is greater than $25.
The previous example highlights -- at a very basic level -- how options work. The option buyer pays a seller to take on the obligation of covering losses past a certain level and time. If the seller is mechanical in his or her approach of managing positions, then a positive expectancy is possible.
When purchasing options, one must be correct in their assumption on direction, time, and volatility. When selling options, one must manage aggressively positions, hedging against delta, gamma and vega risk.
As stated earlier, options pricing is derived from models that take into account the market environment (the price of security and demand for protection, among other things). Resulting model outputs are the following:
It’s important to note that options sellers have an embedded edge: volatility. Volatility is derived from demand; when demand for an option rises, volatility and option premiums spike.
However, demand for an option -- alone -- does not necessarily mean an underlying security will actually move, it just means that fear has compelled market participants to increase their buying of what inherently is insurance. As is true for most other aspects in life, fear is blown out of proportion and hence this is what happens in the derivatives market: fear is overstated and volatility pumps premium in options, most of which expire worthless.
When finding and executing on opportunities in the options market, it is important to have access to two major things: liquidity and quality, low-cost broker.
Here’s an overview of some of the top option-trading platforms based on experience, trading style, and cost.
Interactive Brokers Group, Inc. (NASDAQ: IBKR), a former options market-making firm, is a deep-discount electronic access broker for online equity, options, futures, and forex trading.
Two choices are available when customers open accounts: Pro and Lite.
With Pro, users pay commissions but receive smart routing and best execution.
In an interview late last year, Steve Sanders, the company’s executive vice president of marketing and product development said “According to IHS Markit, our clients save 43 cents per 100 shares by using our smart router. If you take the average trade size, that works out to about $6 or $7 per trade.”
The Lite service offers no minimum balance and maintenance fees, interest on idle cash, free market data, mobile and desktop platforms, and access to over 120 global market centers.
Tastyworks, developed by former Cboe Global Markets, Inc. (BATS: CBOE) floor traders, the experts behind thinkorswim Group Inc., and the famous tastytrade media network, is a discount broker for equity, options, and futures trading.
The firm’s mobile and desktop platforms offer users professional analysis and order management tools. Core features include an intuitive curve analysis feature that allows for visual management of trades, quick-roll which allows traders to quickly add duration to positions, and a trade ideas section.
TD Ameritrade Holding Corp. (NASDAQ: AMTD) is for everyone; whether a novice or seasoned professional, TD Ameritrade is a holistic research, trading, and education solution for the equity, options, futures, and forex asset classes.
A core offering is the thinkorswim desktop trading software that came into TD’s ownership after the acquisition of thinkorswim Group Inc., a brokerage firm that placed heavy emphasis on investor education and active trading.
In October, prior to being acquired by Charles Schwab (NYSE: SCHW), TD Ameritrade introduced free trading on online stock, ETF, and options trades making it easier to trade small and often.
As the saying goes, you must give credit where credit is due.
Robinhood has truly democratized investing with its retail trading platform that offers investors no-fee stock, ETF, option, and cryptocurrency trading. The firm was popularized after it became one of the first brokers to disrupt the industry through its no-commission trade offering.
Through Robinhood, basic strategies like covered calls, credit spreads, debit spreads, cash secured puts, and basic long options can be executed.
Additionally, the firm introduced fractional share trading, allowing investors to buy stocks like Amazon Inc. (NASDAQ: AMZN), Apple Inc. (NASDAQ: AAPL), Walt Disney Co. (NYSE: DIS), and thousands of others with as little as $1, according to Robinhood.
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