Listed options are an important financial tool, used by both institutions and major corporates to hedge risks and speculate. For retail investors, listed options are normally used to speculate. The different requirements of options traders are what allow the market to function. Whenever there is a risk a hedger wants to protect against, there is a speculator willing to take the other side of the trade – for a premium.
Options are priced according to a set of metrics named after the letters of the Greek alphabet. The Greeks include; change in option price as it reaches expiry (theta); change in price in relation to the underlying security’s price (delta); change in delta in relation to the underlying security’s price (gamma); relation to changes in the risk-free rate (rho).
Most retail traders probably aren’t familiar with the models used to price options. Some still manage to make a profit. Most don’t, though, so always be careful when entering into speculative options trades.
How do options work?
Options come in two basic varieties; calls and puts. Both give the right but not the obligation to buy (call) or sell (put) the underlying security at a specific price (the strike price) on a specific date (the expiration date). There are different varieties of options, known as ‘American’, ‘Asian’ and ‘European’. American options can be exercised at any time before the expiry date, whereas European options can only be exercised on that date.
Asian options, which have a range of mini expiry dates on each of which the option can be exercised, are used for certain commodities that are delivered in staggered loads such as electricity. The majority of listed equity options are in the European style. FX options are popular in both American and European styles. The majority of resources online deal only with European-style options, and retail traders rarely if ever by the other types.
Listed options exist almost exclusively for equity and FX. Commodity options are products used mostly by professional investors. In theory, non-listed options can include any possible underlying. Clearinghouses and exchanges are only interested in the highest volume of underlying assets, so listed options reflect this.
Hedging with listed options
Both corporates and financial institutions use options to hedge. A pension fund with massive exposure to the S&P500 index via passive ETFs might want to hedge against a downturn in US equities. One option would be to buy put options on the S&P500 with strike prices at say 5 or 10% below current levels. The cost of buying these options would be offset by the protection of the portfolio.
Corporates may instead need to hedge against a sudden increase in the cost of prices. For example, a Chinese company that buys iron ore denominated in Australian Dollars is exposed to an exchange rate risk. Therefore they might buy AUD/CNY calls, so that their financial instruments will return a profit that partly counteracts the increased cost to their business. Hedgers need to find a balance between reducing risk and spending so much hedging that profits are lost.
Speculation with listed options
Financial institutions and retail or professional investors may use options to speculate. Speculation in listed options by banks has been curtailed since 2008, though it still exists. Other institutions on the buy side have taken up the speculative role. Retail investors exclusively use listed options to speculate.
There are various reasons why a speculator might use options instead of outright buying the underlying. For some assets, such as commodities, shorting is difficult. This means put options are the only way to express a negative view in the asset.
For most investors, the customisability of options is what makes them attractive. By layering calls and puts, it is possible to manage quite closely your prospective losses and gains. Strategies such as collars allow for a fixed payoff at certain prices, or can limit the risk to a certain range. The issue is the buyers of these options pay premiums, which can limit the overall return. Well-used, options are a less risky way of participating in upside.
What should retail investors do?
Retail investors should ensure they understand options before buying them. These are complex products, and using them to speculate should only be done by experienced investors with a track record in their chosen market. If you meet those requirements, they can be both profitable and less risky than traditional investing. Always make sure your broker is properly regulated and providing you with a fair price.