DEFINITION…!!!
An option is a derivative contract that gives its owner the right to buy or sell securities at an agreed-upon price within a certain time period. If you’re a new investor, that may be a confusing concept. For the more savvy investor, options trading can be very enticing, because it offers the opportunity to exert more leverage over trades and to apply industry knowledge and high-level strategies.
Key Takeaways:-
- Call” and “put” options contracts (for the right to buy or sell an asset, respectively) give traders more leverage than buying the asset on its own.
- Pricing of options depends on many factors that reflect both the performance of the underlying asset and the terms of the contract itself.
- Options trading is logistically complex and comes with the risk of a highly competitive market and sophisticated investors.
- Options are traded on all types of securities (stocks, bonds, commodities) and currencies, through multiple exchanges.
Options Terminology
To start, it is important to understand what all of the building block terms mean:
- Option: You pay for the option, or right, to make the transaction you want. You are under no obligation to do so.
- Derivative: The option derives its value from that of the underlying asset. This underlying value is one of the determinants of the option’s price.
- Agreed-upon price: This is known as the “strike price.” It doesn’t change over time, no matter what happens to the stock price. It has that name because you will strike when the underlying value makes you money.
- Certain time period: This is the time until the agreed-upon date, known as the “expiration date.” That’s when your option expires. You can exercise your option at the strike price at any time until the expiration date. In Europe, you can only exercise it exactly on the expiration date.
Two Major Types of Options
There are two types of options. One gives you the right to buy the asset, and the other gives you the right to sell it.
Call Option,,,
The right to buy is called a “call option” or a “call.” A call option is “in the money” when the strike price is below the underlying stock value. If you were to buy the option and sell the stock today, you’d make money, provided the sale price were more than the premium paid for it.
You buy call options when you believe the security will rise in value before the exercise date. If that happens, you’ll exercise the option. You’ll buy the security at the strike price and then immediately sell it at the higher market price. If you feel bullish, you might also wait to see whether the price goes even higher. Buyers of call options are called “holders.”
TIP:-If the price rises, you could make a lot more money than if you were to buy the security instead. Even better, you only lose a fixed amount if the price drops. As a result, you can gain a high return for a low investment.
The other advantage is that you can sell the option itself if the price rises. You can make money without ever having to pay for the security.
You would sell a call option if you believe the asset price will drop. If it drops below the strike price, you keep the premium. A seller of a call option is called the “writer.”
Put Option
With a “put option,” or simply a “put,” you purchase the right to sell your stock at the strike price anytime until the expiration day. In other words, you have purchased the option to sell it. A put option is “in the money” when the strike price is above the underlying stock value. So, if you were to buy the option to sell, and then buy the stock today, you’d make money, because your purchase price would have been lower than your sale price.
Why Trade Options?
Options give you many advantages, but they come with high risks. The biggest advantage is that you don’t own the underlying asset. You can benefit from the value of the asset, but you don’t have to transport or store it. That’s no big deal for stocks, bonds, or currency, but it could be a challenge for commodities.
It also allows you to use leverage. You only have to pay for the cost of the option, not the entire asset. If you buy a call option, and the price rises, you make all that profit without much investment. Your risk is much smaller if you buy a call option. You won’t lose more than the premium, even if the asset’s price falls to zero.
Put options can protect your investments against a decline in market prices by properly hedging your existing positions. Long-term equity anticipation securities (LEAP options) allow you to protect against drops in stock prices for up to two years. Call options can also allow you to speculate on upside moves by allowing you the right to buy a stock at a lower price.
You can also earn an income on assets you own. If you sell a call option against stock you already own, you earn income from the premiums. The biggest risk is that if the stock price rises, you lose the potential for upside profit. This is called a “covered call strategy.”
TIP:- “If you get good at options, you can combine them in strategic ways to safeguard your investments”
“DISCLAIMER”
The SHRI RAM TRADERS CLUB does not provide investment advice. Options trading is considered speculative with high risks of loss of principal. This article should not be considered advice or a strategy for trading. Please speak with a financial planner regarding investments. This post is only for educational purpose.
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