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Options for Speculation

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Options for Speculation

One of the reasons options are useful for speculating on underlying asset prices in the future is that they allow traders to obtain a leveraged position in the underlying. Leverage refers to the use of debt to increase buying power and potentially amplify returns from an investment. Since options don’t require borrowing to implement, the associated leveraged exposure is often referred to as embedded leverage.

Options for leverage

Options allow a trader to gain exposure to the upside or downside of an asset with less capital than if the trader were to long or short the asset. The following example helps explain how.

Suppose the price of 1 share of stock GME is $200 today, but the price of a call option on GME (with a strike price of $240 in one week for 100 shares of GME), is $2. In the US equity options market, one option contract is standardized to represent the right to purchase 100 shares of the underlying stock. Therefore, with $200, a trader could either buy a long position of 1 share of GME or gain exposure to the upside of a position of 100 shares by buying the call option above.

Let’s say the trader buys the option with $200. If the stock price of GME is $245 two months from now, then their position is worth $(max(0, 245–240))*100 = $500. But if the stock price is $190, their position is worth nothing since no one would want to buy shares at the strike price of $240. Written out, this position is worth $(max(0, 190–240))*100 = 0. If the trader had bought 1 share of GME stock instead, they would have a position worth $245 in the first case and $190 in the latter, with $45 and -$10 profits, respectively. In this example, the call option position gives the trader leveraged exposure to the upside of the underlier because the profits of $500 greatly exceed $45.

Therefore, options traders can control the profits on a much greater number of shares for the cost of a single share — this is referred to as embedded leverage in options trading.

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No margin calls

Options are also a more capital efficient way of obtaining a leveraged position in the underlier compared to borrowing. If instead, one were to implement this strategy by borrowing capital to purchase the underlier, they would have to satisfy margin requirements periodically before expiration. For example, suppose that before expiration, the purchased asset goes below the purchase price of $200 to $195, then the trader will be on the hook for at least $5 per share to include in their margin. If they are not able to satisfy this, some or all of their positions may be liquidated in what is called a margin call, reducing or eliminating their ability to profit at expiration. On the other hand, the call option would allow the trader to weather the interim price fluctuations until expiration, when the asset price could be profitable to their option position.

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Capped Losses

Another benefit of purchasing options to speculate on asset prices is that the losses are capped to the initial investment. For example, if a trader wishes to gain short exposure to an asset, one way of going about it would be to short the asset. However, if the price of the asset were to skyrocket after the trader shorts it, they would be on the hook for the significant losses incurred by this price movement. However, if the trader were to have purchased a put option, the worst-case scenario, in this case, would be that the option expires worthless. So the max loss is limited to the premium paid for that option.

Summary

Purchasing options allows for a trader to minimize downside risks and amplify returns generated by price movements in an underlying. Options are also a more capital efficient way to achieve leveraged exposure than borrowing since they are not subject to margin requirements.

For next time

In the next post, we’ll look at Options Spreads. Meanwhile, follow our progress on the Arrow platform at arrowdfms.comTwitterTelegram, or Discord.