Options are a good way to hedge your bets
Option contracts can be a powerful tool in financial markets. Professional traders use them to achieve one of two objectives (or both). The first is to hedge against potential market fluctuations, and the second is to earn money. This is not to say that the two objectives cannot be achieved together. However, each trader has their own strategy, and options can be useful in most strategies.
What are vanilla options?
Options are contracts that enable their holder to buy or sell an instrument at a predetermined price before a specific deadline. Once the deadline passes, the contract expires and cannot be exercised anymore. There are two types of vanilla options, call options (i.e., the right to buy), and put options (the right to sell). Neither put or call options entail an obligation to buy or sell the underlying asset, but rather only the right to do so.
Vanilla option contracts have no extra features, and hence the name “vanilla”. There are many other types of options like exotic or digital options, among others. However, vanilla options are a good place to start for those with little knowledge of this world due to their simplicity, and are available from many online brokers, Easymarkets being one example.
How to empower your strategy with options
For the most part, trading strategies are about predicting price movement, acting on your predictions, and limiting your downside in case the market does not go your way. Options play a key role in the sense that they can act as a cushion against heavy losses, or a winning card that you can use to your advantage when you predict price movements correctly.
Here’s a smart way to use options, to get you started
Let us say you have bought several WTI oil contracts, and you expect the price to go up to $100 from $82 per barrel. However, you are worried about geopolitical events severely impacting the price of oil and pushing it downward with additional supply. Thus, you buy a put option on oil, which enables you to sell the oil you have at $80 within a period of a few months.
The outcome before the expiry of the options contract could be one of two: either the price goes up to $100 and thus you do not need to exercise the option, or the price goes down to $70 which means you can sell your oil for $80 a barrel even though the actual price is $70. The result is that the option helped limit your losses.
Pricing of options depends on market expectations
The above example shows that options ensures that you only have either gains, or limited losses. In other words, options trim negative outcomes to some extent. But even though this works well in many cases, options are often not cheap. Their price essentially depends on market expectations.
Let us go back to the oil example. If the market expects oil prices to drop, then it will be very hard to find put options to buy at a cheap price (called option premium). This makes it not worthwhile to buy them. The lesson here is that for options to be profitable, you might need to be trading against the popular opinion.
Summary
Vanilla options are a great addition to your portfolio and trading strategy, as they reduce potential volatility in earnings. However, they come at a price. You need to ensure that the benefits outweigh the costs before trading them.