Option trading has become increasingly popular over the past two decades and is our primary focus at TheoTrade, a training education firm specializing in the education of stocks, options, and futures. In actuality, option trading has been around for millennia, with roots dating as far back as ancient Greece. Let’s look at the origins of option contracts and how option contracts are structured today.
Greek Philosopher to Trader
You’ve probably heard the phrase “those who can’t…teach.” What happens if you’re not great at being a teacher or philosopher? In ancient Greece, apparently, you are a trader.
In the 6th century B.C., Aristotle relayed the story of a fellow philosopher named Thales and his use of an option-type agreement for the olive harvest. Apparently, Thales wasn’t the greatest philosopher and didn’t have a lot of resources to corner the olive market. Instead, he placed a deposit with local olive presses anticipating a large harvest the following year.
Securing the rights so far in advance allowed him to purchase those rights cheaply. The following year, the harvest was abundant, and Thales was able to charge high prices for the use of the presses he had secured a year earlier.
What is an Option?
An option is a derivative contract that gives the holder the right to buy (a call) or sell (a put) the underlying, at a predetermined price (the strike price), on or before a particular date (the expiration date). For every call and put contract, there is a buyer and seller of the option. In this case, the buyer paying the premium has the right, and the seller receiving the premium has the obligation.
For a call option, the buyer pays the premium and anticipates that the underlying security price will rise before the expiration date. The seller receiving the premium expects the underlying security to close below the strike price by the expiration. The call seller has an obligation to sell the stock to the buyer.
For a put option, the buyer anticipates the price will fall below a certain number before expiration. The option contract gives them the right to sell the underlying at a potentially higher price, and the put seller carries the obligation to sell it to them at the strike price.
Sound familiar? Thales had purchased the right but not the obligation to use the olive presses for a relatively small premium. The owners of the olive presses received his payment and were thus obligated to let him use the presses following the harvest. In the case of Thales, his small premium brought him massive returns!
One of the most attractive features of option products is that they can be traded on equities, index, and futures. While an olive press may not be a choice, you can buy or sell an option contract based on the direction of gold or oil prices. If you like the burgers at Shake Shack, drink Coke, or shop at Walmart, you can trade options on those companies as well. Even if you just had a feeling about the direction of the S&P 500 Index, you could trade an option on the S&P index futures, equity ETF, or Index.
The ability to trade a variety of products isn’t the only attractive feature of options. The leverage allows you to be like Thales and risk very little for your ability to trade the direction of the underlying stock, futures, or index. For example, one of TheoTrade’s more popular strategies is an In/Out Spread. This strategy typically risks around $100 per contract, and we target a 55% return within thirty days.
Another attractive feature is that you don’t have to take a strong stand on the direction of the underlying. Options are all about the probability of the price doing something. As an option seller, you could potentially sell an option with a high probability of expiring worthless. Selling these types of options and hedging risk is at the center of our Ultima premium-selling strategy.
To summarize, here are some of the main advantages and disadvantages of trading options:
- Options give the holder the opportunity of maximum gain through leverage.
- Options can be used as risk-management and loss-prevention tools.
- Options can be sold to earn premiums and create cash flow.
- The buyer/owner can lose their entire investment.
- The limited life of an option is a double-edged sword; a disadvantage if you’re a buyer but a distinct advantage if you’re a seller.
Options are an amazing product that allows investors to trade based on their interests. Whether your account is small or large, you can be a buyer or seller of an option contract. You can construct low-cost spread trades or sell premium with a higher probability of success. Finally, you can also reduce the risk of your option or stock trades with simple hedging techniques.
While this veritable buffet of option possibilities can be intimidating, it doesn’t have to be. Learning a process and focusing on a single product can be done with minimal risk and allows you to hone your skills. It’s what we do every day at TheoTrade. So why not try your hand at it? Who knows: you might end up a modern-day Thales.