What kind of thing is an option?

Background: Xinhua News Agency, Shanghai, Feb. 9 New Media Report. The first market-based risk transfer tool for the mainland Chinese stock market made a high-profile debut on the Shanghai Stock Exchange on the 9th, and the Shanghai Stock Exchange 50 ETF options contract was officially listed. This marks the official entry of stock options as financial derivatives into the Chinese capital market.

The Chinese options market has great potential for development. Stock ETF options are mature derivatives of the international capital market. Their combined application is very complex. They are not only a tool for managing risk, but they can also cause new risks. They are a double-edged sword. How to gain profit and avoid harm, make good use of this double-edged sword and play its unique role.

I first came into contact with options when I came to the US in 2010. We have a course that specializes in financial derivatives, including other financial derivatives such as options and futures. Since 2011, we have also had more than five years of experience trading US stocks and options. By going long on individual stock bullish options, we have also obtained profits of more than 50 times. There are times when we have lost more than 1 times by selling single options on call options, and there are times when we can achieve a stable annualized yield of 20% through options strategies.

Individual investors generally increase leverage through option buyers, and professional institutional investors generally make stable profits by receiving royalties as option sellers; we have seen individual investors who have obtained nearly 30 times the return by buying options, and have also seen an annualized return of more than 60%, and the asset size has grown from 3 billion US dollars to 6 billion US dollars in 3 years. In the past four years, we have also seen that many newbies to options trading have suffered a lot of losses in options, and many people have liquidated their positions due to taking long options.

Some people have earned hundreds of times returns through options, others hedge losses caused by falling stocks through options, and others have used options for risk-free arbitrage. I believe many people have heard of options for the first time. Many people don't know what options actually are? How do I trade? What is the difference between options and futures? What kind of relationships and connections are there with stocks? With so many options strategies, which one to choose to maximize profits?

Through a series of articles, we hope to help everyone understand what options really are, starting with the simplest basic concepts, to complex strategy combinations, to incorporating practical applications. Our series of articles on options is suitable for people who have no basic knowledge of options. It is also suitable for people who have some basic knowledge but are unable to use options flexibly for hedging and arbitrage, and more suitable for traders who want to make stable profits through options.

To understand what options are, let's start with the history of options. Options trading first began in the US and European markets in the late 18th century. Until April 26, 1973, when the Chicago Board Options Exchange (CBOE) was established to carry out unified and standardized options contract trading, up to now, more than 2,500 stocks and more than 60 stock indices have offered corresponding options trading on all exchanges across the US.

In January 1983, the Chicago Mercantile Exchange proposed S&P 500 stock index options, and the New York Stock Exchange also introduced the New York Stock Exchange stock index futures options trading. Currently, options exchanges are spread all over the world, and the Chicago Board Options Exchange (CBOE) is the largest options exchange in the world.

Simply put, an option (option) is a type of option. It refers to the right to buy or sell a certain amount of a specific stock or commodity at a specific price at a specific time in the future. The holder of an option can choose to buy or not buy, sell or not sell the right within the time specified in the option. He can exercise that right or relinquish that right, while the seller of the option only bears the obligation stipulated in the option contract.

Why are we writing this article about options? The reason is simple: options are widely used in the world financial market. An important feature of the US market is that options can be traded. Options trading was also introduced domestically in early 2015. Currently, there is only one type of SSE 50 ETF option.

Although options investment takes some time to fully master, it would be a pity to lose it because you don't understand it. After all, options are a powerful investment tool that can bring many benefits to investors. Options are a powerful tool for investors to invest, arbitrage, risk management, and even speculate. Here are a few of the benefits and effects of options:

1. Options provide leverage to improve the efficiency of capital use

Providing leverage is an important reason why options attract investors. Investors only need to pay a small premium to benefit from changes in the price of large assets, but at the same time, the risk will also be amplified.

At the end of 2012, the quantum fund owned by financial giant Soros used about 30 million US dollars to knock out foreign exchange options with an imaginary exercise price of 90-95, making a profit of 1 billion US dollars, which is equivalent to a capital increase of more than 30 times, reflecting the leverability of options. At the same time, the risk is also quite high, which requires investors to determine the direction of investment;

As an example, the current price of Apple stock is 118, corresponding to the exercise price of 120, and the price of a call option one week after the expiration date is 1.47. Assuming that the price of Apple stock rises to 130 after a week, this is more than 5 times the profit return of options trading: (10-1.47) /1.47 = 533%.

The leverage ratio of options can also be adjusted by trading options at different prices. For example, if you want to use a lower leverage ratio, you can buy options within the deep price (In the money); if you want a higher leverage ratio, you can buy out of the money options (Out of the money).

2. Hedging market risks

Many investors like to hold some stocks for a long time, but are afraid of falling stock prices. At this time, investors can buy put options (puts) to hedge against downside risks in the market. For example, investors hold 1,000 shares of Apple, with a share price of 118 yuan. Each share uses a premium of 1.50 yuan to buy 10 put options with an exercise price of 115 yuan to hedge against losses caused by falling stock prices.

If the stock price falls to 100 yuan on the maturity date, the profit on the option side (15-1.5) *10*100 = 13,500 yuan will offset the loss of 18,000 in some of the underlying stocks, reducing the loss from 15.2% to 3.8%. This strategy is also known as the protective selling strategy Protective Put.

3. Locking in profits

Investors hold the underlying stock and have accumulated a certain amount of profit. If they are uncertain about the future market and are worried that the stock price will fall, but if they sell the stock they are worried that the stock price will continue to rise and lose the opportunity to obtain higher profits, investors have two countermeasures at this time:

(1) If investors need to cash out their shares, they can sell stocks and buy equal-value subscription options at the same time;

(2) If you have a large number of positions and the impact cost of selling stocks is high, you can buy put options on your opponent's shares to lock in profits.

4. Increase revenue

Although selling subscription and put options is a high-risk strategy, under certain circumstances, selling options can have the effect of increasing revenue. For example, in the case of holding the underlying stock, if the stock price consolidates at a high level, and investors are neutral or slightly optimistic about the future trend of the target, and they are willing to reduce their stock holdings when the stock price rises to a certain level, they can sell subscription options to increase profits. This strategy is also known as a covered call for insured bullish options.

5. Buy the target stock at a lower price than the market price

Investors want to buy stocks, but they think that the current stock price is high. If they want to wait for the stock price to fall to the low level they want before buying them, they can sell put options with an issue price close to the target purchase price. Also, take Apple's stock as an example. The current price is 118. If the price of Apple falls below 115, investors are happy to buy it. If the investor sells for a put with an exercise price of 115 and expires one month, they can get a premium of 1 yuan.

If the stock price is higher than the exercise price at the time of expiration, and the option seller gets a premium; assuming that the valuation is lower than the exercise price of 115 at maturity, the option seller will get the stock from the option buyer at 115. Plus 1 yuan from the previous sale of the rights, the average cost to buy the original Apple stock is only 114.

6. Minimize risk

For option buyers, options provide limited risk, that is, they limit the maximum loss, that is, the premium paid to buy the option. Assuming Apple shares 118, buying 100 shares of the original stock, the total expenditure is 1,1800 yuan. Assuming Apple goes bankrupt, it will lose 1,1800 yuan.

If we use call options instead of holding positive shares, assuming that a call option with an exercise price of 120 is sold for 1 yuan when it expires after 1 month, we buy 1 lot, which is equivalent to 100 active shares. When stocks rise, we hold call options and enjoy the benefits of rising stocks. Even if Apple goes bankrupt, our biggest loss is the premium of 100 yuan to buy call options.

7. Option capabilities create portfolios that are profitable in any market condition

For investors who simply trade stocks, there is usually only an opportunity to make a profit when the stock rises or falls. Moreover, direct short selling of stocks may face unlimited risks, so that stock investors can only rely on rising stock prices as a way to profit. In the face of market conditions such as consolidation or huge fluctuations in both directions, the only thing stock investors can do is exit and wait and see.

With the help of options, regardless of whether the stock rises or falls, does not rise or fluctuate dramatically in both directions, etc., it is possible to construct a corresponding option portfolio, so that investors can have a chance to make a profit under any market conditions. What is really needed at this time is investors' judgment on market conditions.

After a long period of preparation, we plan to launch a series of articles on options strategies and practical applications. I hope everyone can have a deep understanding of options.

This series of articles first briefly explains the importance of options. Skillfully manipulating options can make you move from passive to active in the face of changing markets. You can better grasp the direction in a volatile market to amplify profits, protect your positions from extreme influence through option combinations in situations where the implied volatility is extreme, and actively earn equity through various operations in a market where the direction is unclear (such as now) to obtain stable income.

Also, being proficient in options allows you to always be on the side with a higher win rate in this game, rather than passively waiting for the market to create opportunities.

We will try to cover everything from the basic concept of options, the advantages and disadvantages of various brokers' options operations, Greeks, the theoretical and practical significance of implicit/historical volatility, basic combination strategies of objects and options, various combinations (Vertical, Butterfly, Calendar, Back, Ratio, Collar, Iron condor), etc. We will also explain practical ideas on many situations based on examples.

I hope that after reading our article, everyone can have a basic understanding of the concept of options, and also be able to skillfully use options as a financial derivative to better serve their investment strategies. Finally, I hope everyone can achieve wealth freedom as soon as possible. Investment is a lifelong thing, and we hope to accompany you on your investment path.

References:

https://www.cs.com.cn/sylm/jsbd/201610/t20161019_5075120.html

https://stock.hexun.com/2015-02-09/173215741.html

https://www.nasdaq.com/investing/options-guide/

https://en.wikipedia.org/wiki/Option_(finance)

https://www.moneyshow.com/articles.asp?aid=optionsidea-22744

https://www.ino.com/blog/2011/05/4-ways-options-are-better-than-stocks/

Author introduction:

Li Qiu, Chief Investment Officer at Paretone Capital. Prior to joining Paretone Capital, he worked for a well-known hedge fund on Wall Street, specializing in designing, developing and improving quantitative trading systems, portfolio optimization systems, and investment strategy evaluation systems. The trading system model developed in the long-term experience of a quantitative hedge fund analyst based on momentum, volatility, and derivatives, combined with big data analysis, has an annual return of over 60%, and is responsible for the development, backtesting, and actual execution of quantitative fund models. Graduated from the University of Southern California with a master's degree in quantitative finance. Senior investors in US stocks, A shares and options options.

Wang Wei, CFA, founder of Paretone Capital. Served as a senior manager at an investment bank and was responsible for mergers and acquisitions financial due diligence. He worked for Huamei Bank, a NASDAQ-listed bank, and worked successively as a management trainee, analyst, and portfolio manager. The total assets of the bank exceeded 33 billion US dollars. It is mainly responsible for bond financing for high-tech enterprises and biomedical companies. It also provides leveraged acquisition debt financing for private equity and listed companies, and participated in debt financing of more than 1 billion US dollars. It is also responsible for the operation of family office funds, participated in five venture capital funds in the US and Canada, and directly participated in more than 50 project investments. He has worked as an analyst at the private equity firm Clean Energy Capital. He is mainly responsible for valuing invested companies and investee companies, as well as industry analysis and investment due diligence. The company's asset management scale is 200 million US dollars. He has been trading A-shares and US stocks for over ten years. He has thoroughly studied options and used options strategies to obtain excessive returns. Bachelor's degree in accounting at Renmin University, graduate student in finance at the University of Arizona, USA, chartered financial analyst.