Using Options for Speculation

Study Notes:

If a trader believes the price of a security will rise or fall, they may use options to build a position that would profit if the security behaved the way they speculate it will. Options allow the investor to profit from movements in the underlying. There are several single and multi-leg strategies investors can use to speculate on the underlying movement or even lack thereof. In this lesson we will define speculation and go over a few simple strategies that will profit if the security behaves in the way the investor speculates it will.

What is speculation?

Speculation in financial terms is defined by Oxford Languages as “investment in stocks, property, or other ventures in the hope of gain but with the risk of loss”.  Options are a financial tool that can be used to facilitate an investor’s belief that a security will rise or fall. In simplest terms a trader who believes a security’s price will rise may purchase a call or sell a put. Conversely, if they believe the security will fall then they may want to sell a call or purchase a put. This will be illustrated later in the lesson. Options allow the investor to play a directional movement while outlaying less premium than trading the security itself. Of course, speculative trading has a substantial risk of losing but also can produce more than enough substantial gain to offset the risk of loss if the trade becomes profitable.

Speculators generally focus on shorter term price movements and are willing to take on risks to generate profit whereas investments are generally longer-term commitments to price movement. In a previous lesson on hedging, options were used as a tool to offset the risk of a position.Speculation is the opposite where investors use options to take on risk, and potentially enough profit to offset the risk.

How are Options used for speculation?

Each standard equity option is equal to 100 shares of stock. So, for each option contract an investor takes a position in, it is the equivalent of 100 shares of stock should the option expire in the money.  Through options the trader can take a much larger speculative position instead of buying shares. For example, ABC stock is currently trading at $50 /share. The trader believes that over the next two-months the price of ABC will rise to $60 per share, and wants to profit from that potential increase. They can either buy the stock, buy calls, or sell puts to profit if their belief is correct and the stock rises in price. Each speculative strategy has its own benefits and risks. For the same financial outlay, or less, if the trader’s speculative belief proves true, they will almost always see a greater profit than purchasing just shares in the underlying. As a reminder these are just a few examples of how options strategies work and do not take into consideration other fees and costs like commissions that might impact profit and loss calculations

For each scenario let’s walk through the profit and loss if in two months ABC stock rises to $60, stays at $50, or falls to $40.

Let’s start with speculating using stock, the trader buys 100 shares of stock for $50 a share and pays $5,000.

Scenario 1: In two months, ABC stock is trading at $60, and the trader sells, making a profit of $1,000.

Scenario 2: In two months, ABC stock is trading at $50, and the trader sells for zero profit.

Scenario 3: In two months, ABC stock is trading at $40, and the trader sells for a loss of $1,000. The trader could also hold on to their position for an unrealized loss of $1,000 but they would still own the shares.

Second, what happens when the trader uses options to speculate? Let’s assume that the 50 strike calls expiring two months out are trading for $5 a contract. The trader decides to buy 10 contracts (remember each contract equals 100 shares of stock so a $5 contract costs $500.) The cost of the 10 contracts is $5,000.

 Scenario 1: In two months, ABC stock is trading at $60, and the trader can sell the 10 option contracts for $10, making a profit of $5,000.

$10 x 10 contracts x 100 = $10,000 – initial investment of $5,000 = $5,000

Scenario 2: In two months, ABC stock is trading at $50, and the trader can either exercise the calls paying $50 a share for up to 10,000 shares or let the calls expire. Either way the initial $5,000 spent on the call premium is a loss.

Scenario 3: In two months, ABC stock is trading at $49.99 or lower, and the calls expire worthless, leaving the investor with a $5,000 loss.

Finally, the trader decides to sell the 50 puts expiring two months out on ABC stock. They sell 10 puts for $5 a contract, taking in a total of $5,000 in option premium.

Scenario 1: In two months, ABC stock is trading $50.01 or higher, the puts expire worthless, and the investor makes a profit of $5,000.

Scenario 2:  In two months, ABC stock is trading at $50. The trader could most likely buy them back for less than $0.05 at some point on the day of expiration and realize a profit of close to the $5,000 premium taken in for selling the puts.

Scenario 3: In two months, ABC stock is trading at $40. The puts are assigned at expiration and the investor is forced to buy the stock at $50 while it is trading in the open market at $40. If the trader sells the stock to close out the position, they will realize a loss of $5,000.

-$5,000 = $40 x 10000 = $40,000 (sale of ABC stock) + $5,000 (premium taken in for selling puts) – $50 x 10,000 =$50,000 (purchase of ABC stock at strike price)

Options allow the investor to take a much larger position with the same capital expenditure versus using the underlying.  However, there is potentially greater risk of loss, either in financial terms or a percentage chance of loss occurring.

How to use multi-leg option strategies to speculate

A trader can also use multi-leg option spreads to speculate on the underlying movement, or lack of movement as well. One common strategy is using straddles. A long straddle position is a long call and put in the same strike and same expiration. Conversely, a short straddle is a short call and put in the same strike and expiration. A trader may speculate that the price of ABC stock will move due to an upcoming event such as earnings but be unsure of whether the stock will rise or fall. In this case they may want to buy a straddle, which benefits if the stock moves either up or down. Of course, if the trader speculates that the stock will stay within a certain range during that period, they may sell the straddle to take in the premium. Let’s walk through using the straddle combination strategy for speculation.

XYZ stock is trading at $100 and its earnings are scheduled to be released a little over two months from today. The trader speculates that stock will move $10 on the earnings news but is unsure if the price will rise or fall. In this scenario a trader may want to buy a straddle to profit from either an up or down move in XYZ stock.

In this example the investor buys the XYZ 100 straddle expiring two months away paying $4.

Scenario 1: After earnings XYZ stock rises to $108, the trader profits $400. Note that the trader could earn even higher profits the higher XYZ stock rises.

($8 x 100) – ($4 x 100) = $400

Scenario 2: After earnings XYZ stock falls to $90, the trader profits $600. Note that the trader could profit more if XYZ stock falls to an even lower price range

($10 x 100) – ($4 x 100) = $600

Scenario 3: After earnings XYZ stock stays at $100, the trader loses the $400 they paid for the long straddle.

Conversely, another trader believes that XYZ stock will stay relatively flat or only move within a few dollars up or down after earnings, so they sell the XYZ 100 straddle for $4.

Scenario 1: After earnings XYZ stock rises to $108, the trader loses $400, note that the trader will have much higher losses if XYZ stock rises to an even greater level.

($4 x 100) – ($8x 100) = -$400

Scenario 2: After earnings XYZ stock falls to $90, the trader loses $600. Note the trader will have much higher losses as the stock price decreases below $90.

($400 x 100) – ($10 x 100) = -$600

Scenario 3: After earning XYZ stock stays at $100, the trader will profit the $400 they sold the straddle for. 

There are many other multi-leg strategies that allow the trader to speculate on the underlying movement. For examples of real option trades read the IBKR OptionWatch section on the IBKRCampus.