An Overview of the Option Markets (a jargon free zone)

The thing about options is that there are so many terms and concepts to learn and you’ll find even an introductory level article will be full of them. It means these things called “options” can be a little hard to understand at first.

Well with that in mind, let’s try and write an article without a single piece of options jargon. Instead of coming from the ‘what are options?’ point of view, let’s consider why you should trade them or better still ‘what’s in it for you?’

Options in perspective

While options were initially developed as a tool for protecting the downside in a stock, commodity or portfolio, they have since grown as a trading tool in their own right. Most of the volume in option markets around the world comes solely from traders buying and selling for profit.

One thing that does attract traders to the option market is the ability to place a strategy based on a very specific or even a vague view. In this respect, options are extremely flexible.

Consider having a view on your favourite stock. Well in most cases all you can do is buy it and hope it goes up. That is, you can make money solely from the share price moving higher. In some cases, you may also be able to sell the stock before buying it back to profit from a fall in the price.

With a stock, that’s about it – you can buy it or you can sell it. Options however make available a much wider range of strategies.

Consider the analogy of gambling down at the race track. The bookies set the odds and take bets from the punters.

The strategy of buying shares is much like the punter placing a single bet on a specific horse. The horse will either get a place or it won’t. The share price will either go up or down.

Think about things from the bookie’s point of view. They’re in a pretty good position. They are there to sell the bet to the punter. That is, to be on the opposite side of the punter’s transaction. Not only that, they can make just as many bets as you can. So the gambling strategies available to them are much greater than that of the punter. The bookie can be both the buyer and the seller.

You can do that in options. Think of any option strategy as simply a bet that the market will do one thing or another. As an options trader, you can be on either side of the bet. That is, you can make a bet that the market will do a certain something or you can sell that bet to someone else. You can be the punter or the bookie.

Much ado about options…

Down at the race track, there are a wide range of strategies you can place. You can bet that a horse will win or take a place. You can bet on trifectas, quinellas etc.

That is nothing compared to what you can do with options. Let’s look at a range of strategies and remember – no jargon. You will not walk away from this article, ready to leave your job and become an options trader. The idea here is to give you an idea of what you can do with options.

First and foremost we will lay some ground work. Options give you the ability to make a bet not only on whether your stock will go up or down. You can also bet on exactly how far it will go AND over what time frame. Not only that, but you can also take the opposite view of anyone on the market (much like the bookie does). Not only that! You can also make multiple bets.

Markets in which options are traded:

  • Local shares.
  • International shares.
  • Commodities such as gold, wheat and oil.
  • Financial futures such as Bonds & Bank Bills.
  • Stock Indices such as the ASX200 and the DJIA.
  • Many other liquid trading markets.

If you consider just that last paragraph, you can come up with many, many, many combinations of strategies. Here we will look at a few different strategies and look at what you could do with just shares and with options.

Outlook#1: You think the share price is going higher

With shares, this one is pretty simple – you buy the stock. With options, you can place a similar strategy that will tie up less capital and have similar profit potential. Alternatively, you could even risk the same amount as you would the stock but stand to make a much greater amount.

Where the share trading strategy falls short is when you want to be more specific with your view. Let’s say you have a view about the magnitude of the move. With shares, there is still just one strategy.

With options, you can place a strategy that will profit from a small, medium or large in the share price. In fact you can be very exacting with your view and place an appropriate strategy at an appropriate cost.

If we think back to the bookie analogy, they will set their odds based on the chances of that horse winning or taking a place. Consider two horses: one with odds of 2:1; the other with odds of 100:1.

With a 2:1 horse, you can bet $1 and stand to win $2. With the 100:1, you bet the same dollar but stand to win $100. The difference represents the chances that each horse has of winning the race. They are priced according to their probabilities.

Options work in exactly the same way. Consider Rio Tinto at $124.00. You can place a bet that the stock will go to $130 or $150. If you look at ‘option bets’ as having a specific cost, which bet do you think will cost more and why? Dollar for dollar, the $130 bet must cost more because there is a higher chance of the market getting to $130 than $150. It’s just like the 2:1 and 100:1 bets.

By the way, you can do all of this over different time frames. Your view might be for a quick move, say over a month or over the longer term, like six months. Again you will get what you pay for. A longer term bet will cost more. A short term bet might be cheaper, but you’ll have a lower chance of being right.


Outlook#2: You don’t think the share price is going higher

You could sell the stock (if that stock is available for short selling).

With options however, there are dozens of different strategies you could place here depending on your exact view. So you can place a strategy that says Rio will fall to $100 or $90 or $50 or wherever. Each of these bets would have their own cost and payoff (also called risk and reward).

Another thing you can do with options is not bet where the market is heading, but where it’s not heading. So you could say “I think the market will go down, sideways to even a little higher, but never get to $130 in the next two months”. Well you can place a strategy that makes money from this view.

It is important to remember that the options market allows you to be either the punter or the bookie. So here you can do the opposite of betting that the stock will go to $30. In a way, you are acting like the bookie here. You are in fact taking the bet from someone else.

Outlook#3: You think the share price is going to be stuck in a range for a while – a few months at least.

Well this is similar to outlook#2 above, but you will in fact be taking two bets. One that the market will not go up and one that it will not go down. With options, you can specify what range you expect the market to remain within over a certain time.

Looking at Rio again, we can place a bet that says the market will stay within $120 to $130 over the next month, or we can have less exact view of say $100 to $140.

Thinking back to concept of each bet having a certain cost and a certain payoff, you would say the $120-$130 bet should have a greater payoff than the $100-$140 bet. It is logical isn’t it? The $10 range bet has a smaller probability of being correct than the $40 range bet. If you are taking the best, you’ll need to be paid more for it.

Outlook#4: You are unsure about direction, but you feel the share price is set to break out and become much more active.

Well this is just the opposite of the previous outlook. We know you can take a bet that the market will stay in a range. You can instead take a bet that the market will not stay in a range. In fact, you are just standing on the opposite side of the transaction (or ‘trade’).

Now think about the costs of betting on a breakout from the $120 to $130 area compared to the $100 to $140 area. What one will cost more? It’s simple. It’s the $120 to $130 bet. Why? Because this bet has probabilities on its side. It has a better chance of making money than the $100-$140 bet.

Outlook#5, 6, 7, 8…

This list could go on and on, but you get the point by now. Options allow you so much more flexibility in the type of strategies you want to place.

The number one thing you need to trade options: Education

This is the most important thing of all. You really need to spend some time teaching yourself a few things.

A good tip is not to waste any money on expensive seminars that claim to show you some type of secret and amazing technique. Start with a couple of good books and read them over a couple of times. Two good books are:

  • Options: A Complete Guide. 2nd Edition. Guy Bower
  • Options Trading Strategies that Work. William Eng /Daryl Guppy

These two will cost you about $80 all up and if you read these a couple of times, chances are you will know more than most brokers and other traders. That’s a fact! After this, you will then consider choosing a broker, buying software, getting data etc. First things first however.

Conclusion

Hopefully this article has got you wondering ‘how?’. We have listed a few possible strategies: ‘you can make money from this or that’, but not talked about how to do it. Well learning about the mechanics is the next step.

From a general point of view, if there is one word we can use to describe options, it is flexible. Options give you the flexibility to take very specific or very vague views on the market and potentially profit from it.

How flexible are shares? You buy them and hope the go up or hope you get a nice dividend. That’s about it really… Options on the other hand open up a range of new strategies. These strategies all have varying degrees of risk and varying degrees of profit potential.

For the person that wants to take an active interest in their trading, options markets are ideal. Given their diversity, they can be suitable for the risk seeker or the risk adverse or anyone in between. It may take a little homework before you can be armed with all the strategies, but it can be a good bet to make.