June 24, 2024

Demystifying options trading

Options trading can initially seem complex and daunting, but it offers Singaporean investors valuable opportunities to diversify their portfolios and manage risk effectively. This article aims to demystify options trading for beginners, providing an accessible overview of key strategies and concepts.

By understanding the basics and gradually building confidence, investors can embark on their options trading journey with clarity and purpose.

Understanding options: Calls and puts

Options are financial instruments that grant the holder the chance but not the obligation to buy or resell an asset at a set price (strike price) within a set timeframe (expiration date). Calls are typically used when an investor expects the underlying asset’s price to rise, while puts are employed when a price decline is anticipated.

For example, if you believe a Singaporean stock is poised for growth, you can purchase a call option to buy it at a predetermined price if the stock’s value appreciates. Conversely, if a stock’s value falls, you might buy a put option to sell at a higher price than the market value.

Covered calls: Generating income with stock ownership

Covered calls are a conservative options strategy suitable for beginners trading through reputable brokers such as those available at home.saxo. It involves owning the underlying asset (e.g., a stock) and selling a call option on that asset. This strategy can potentially generate income from the premium received for selling the call option, which can help offset potential losses if the stock’s price decreases.

For instance, if you own shares of a Singaporean company, you can sell call options on those shares. If the stock’s price remains stable or declines slightly, the call options expire worthless, and you keep the premium. If the stock’s price rises significantly, you may be obligated to sell your shares at the strike price but still benefit from the premium received.

Protective puts: Hedging against downside risk

Protective puts, also known as “married puts,” are a defensive strategy that can help mitigate losses. This strategy involves buying a put option for each share of your underlying asset. If the asset’s price falls, the put option provides a financial cushion by allowing you to sell at the strike price, even if the market price is lower.

For example, you can purchase corresponding put options if you own Singaporean stocks and are concerned about a potential market downturn. If the market experiences a decline, the put options increase in value, offsetting losses incurred on your stock holdings.

Bullish strategies: Profiting from price increases

Bullish strategies are ideal when an investor anticipates a rise in the underlying asset’s price. Two common bullish strategies are the long call and the bull call spread.

  • Long call: This straightforward strategy involves buying call options on an underlying asset. If the asset’s price rises above the strike price, the call options become profitable. Long calls offer unlimited profit potential, as there is no cap on the asset’s price.
  • Bull call spread: A bull call spread involves both buying and selling call options. It entails purchasing a call option with a reduced strike price while selling a call option with a higher strike price on the same underlying asset. This strategy restricts potential gains and losses but enables investors to capitalise on a moderate price increase.

Bearish strategies: Taking advantageof price decreases

Bearish strategies are employed when an investor expects the underlying asset’s price to decline. Two common bearish strategies are the long put and the bear put spread.

  • Long put: Similar to the long call, the long put strategy involves buying options on an underlying asset. If the asset’s price falls below the strike price, the put options become lucrative. Long puts offer unlimited profit potential, as the asset’s price can drop to zero.
  • Bear put spread: A bear put spread combines purchasing and reselling options. It entails purchasing a higher-strike put option and selling a lower-strike put option on the same underlying asset at the same time. This strategy limits potential gains and losses but allows investors to potentially profit from a moderate price decline.

All things considered

Listed options trading can be a smooth endeavour for Singaporean investors. By grasping the fundamentals of calls and puts and exploring strategies such as covered calls, protective puts, and various bullish and bearish approaches, beginners can develop a solid foundation for options trading. Moreover, it’s essential for novice traders to start with a clear understanding of their risk tolerance and to practise prudent risk management.

While options trading offers profit opportunities, it also involves risks. Therefore, beginners should consider paper trading (simulated trading without real money) to gain experience before venturing into live markets. Seeking education and guidance from reputable sources can further enhance a novice trader’s ability to navigate the world of options trading with confidence and competence. As with any investment, conducting thorough research and making well-informed decisions tailored to one’s financial goals and risk appetite is essential.