Options are commonly known as derivatives. To simplify, options give buyers the right but not the obligation to buy or sell an asset later. You can buy or sell an option contract that gives you the legal rights to buy or sell 100 shares of stocks in your next trading session.
Option contracts are traded over-the-counter (OTC) and on major exchanges like the CBOE, CME Group and the Singapore Exchange (SGX).
How do options trading work?
Before buying any options, traders must understand how they work. Options are traded regularly on SGX, so there should be no problems getting started with them here in Singapore.
Typically options are bought for one of two reasons:
Making a bet on the direction of the underlying security’s price
Protecting an existing or anticipated position in the underlying security from unwanted price movements.
Primary risks of trading in options
It is important to remember that you are paying for the right, but not the obligation, to take a specific action when buying options. As a buyer of an option, you have three primary risks:
1) The market may move against your position, and you may not be able to sell the option back at a profit
2) The option may expire worthless if the underlying security’s price does not move in the desired direction before the expiration
3) You may be called away (forced to sell your position) if the underlying security’s price moves in a way you did not anticipate.
What is a Wash Sale?
If you buy an option contract to sell it if it moves against your position, but you’re unable to at a profit, that is called a “Wash Sale”. In this situation, wash sale rules may apply and result in your loss being tax-deductible. Although this is highly unlikely with options as they typically expire within two weeks or less.
As an example: Let’s say we think Company A’s stock price is going down, and we want to hedge our downside by buying puts (options contracts giving us the right to sell 100 shares of Company A at $50 each). If we buy one put with an expiration date in four months for $10, we have paid $10 for the right to sell Company A’s stock at $50 per share, no matter what the market does.
If the stock price falls to $40, we can exercise our option and sell the stock at $50 per share even though it is now worth $40 on the open market. We would then have made a $10 profit on the stock, minus the cost of our option contract. If Company A’s stock price rises to $60, then our put would be worthless as we would not want to sell the shares at $50 when they’re now worth $60 each.
Be aware of the following factors when trading in options
When buying options, it is essential that you are aware of how much you are paying for them and how much you stand to gain or lose if the underlying security’s price moves in the direction you predict.
You will also want to be aware of your potential tax liabilities if you have a loss on an option contract, as it may be tax-deductible depending on your circumstances and how the option is held.
Always remember that buying an option gives you the right but not the obligation to buy or sell a particular position at a later date. This means that there are no guarantees regarding options, and losses can accrue very quickly. Before investing their money, new traders and investors are advised to use a reputable online broker from Saxo Bank. Start trading on a demo account and practise your options trading strategies. For more information, look at this site and start your investment journey today.