In recent years, volume in the options market has exploded as more and more traders shift over to derivatives trading. Last year, the world’s largest options exchange, the CBOE, announced record trading volume with 1.15 billion contracts traded versus 1.12 billion in 2010. Average daily volume for the year was 4.6 million contracts. This marked the fourth straight year that volumes exceeded 1 billion contracts on the CBOE.
The rising popularity of options comes at a time when volume in the equity market has been falling. As more and more liquidity migrates into the options market, these derivative products have become fertile ground for individual traders to hunt for profitable opportunities. Options offer a number of advantages compared to other products such as vanilla equities and futures.
Today’s options market is incredibly vast as more and more products continue to come online. This product diversity provides traders with a tremendous array of potential strategies and profitable niches within the marketplace. Options are available on stocks, stock indices, ETFs, commodity futures, interest rate and foreign exchange products, and even on volatility derivatives such as the CBOE Volatility Index, or VIX.
Not only do traders have a wide variety of different underlying assets to choose from, but within each market there are numerous contract expirations. This allows for a significant number of different strategies to be employed. For example, stock options are now available with weekly expiration dates. These products have become extremely popular in a very short period of time. Options known as LEAPs are on the other end of the timescale, with expirations lasting as long as three years. The most common type of options, however, have monthly expirations.
There are two types of basic options contracts, puts and calls. A put option gives the owner the right to sell a specified amount of an underlying security at a specified price within a specified time. Alternatively, a call option gives the owner the right to buy a specified amount of the underlying security at a specified price within a specified time. Traders can both buy and sell puts and calls to try to generate profits. Many strategies include buying and selling a combination of puts and calls, such as spreads, collars, straddles, strangles, butterflies, and condors. While more advanced options strategies can get complicated, the basics are fairly easy to grasp. Furthermore, many of the most consistently profitable strategies are simple and straightforward.
In addition to the diversity of the options market, there are other distinct advantages to trading these derivatives. In general, call and put options allow traders much more leverage than many other asset classes while also providing the ability to limit risk. This can make options trading an attractive alternative for traders with smaller account sizes. When buying a put or call option, the investor’s risk is limited to the cost of the contracts. In the case of call options, the profit potential is theoretically unlimited. It is not uncommon for traders to realize profits which are multiples of their original capital outlay in a short period of time when trading options.
If, for example, a trader bought 100 shares of a stock that cost $100 per share, their capital outlay would be $10,000. The at-the-money call options on the same stock, however, might only cost $5 per contract. In this case, the trader could buy one contract, which gives them the right to buy 100 shares at a specified price, for $500. Now, let’s say that the stock is trading $10 higher by expiry. The trader’s call options would then be worth $1,000 giving them a profit of $500 on their initial $500 investment. The equity position would be worth $11,000 on a $10,000 investment. You can see that the option returned a 100% profit on the initial investment versus the 10% profit realized by buying the actual stock.
This example highlights the leverage available in the options market. Furthermore, the trader’s risk in this example would have been limited to the $500 capital outlay. If he had bought the stock outright for $10,000 he could have lost considerably more money if the stock had traded sharply down instead of up. While most individual options traders prefer to buy options contracts because of the limited risk and possibility of very large short-term profits, selling options can be a very high probability strategy for traders who are well-capitalized and have a strong understanding of hedging. In fact, many of the most successful options traders prefer to sell options rather than buy them.
In addition to learning about the wide variety of strategies in the options market, it is important for traders to find the right broker when entering this potentially lucrative arena. Top-tier brokers such as Lightspeed have the ability to route and execute multi-leg orders such as call and put spreads to ensure that you don’t end up with partially filled orders which would result in broken hedges or strategies. Just as importantly, they have the ability to calculate the reduced capital requirements of most hedged options strategies which allows the trader or investor to maximize the use of their capital. As traders become more experienced, these types of orders and automatic margin requirement calculations are essential.
It is also very important to use a broker with very competitive commission rates. Just like in the stock or futures markets, profitable short-term strategies will almost always require very low commission rates to reach their full potential. In today’s competitive markets, individual traders can use any edge that they can get. Options provide a multitude of potentially profitable strategies and niches for the enterprising trader who utilizes the diversity and flexibility that is inherent in this rapidly evolving market.
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