What is option?
Definition
The term option refers to a financial instrument that is based on the value of an underlying security such as a stock. An options contract gives the buyer the option to buy or sell, depending on the type of contract he holds, the underlying asset. Unlike a futures contract, the holder is not obligated to buy or sell the asset if he decides not to. Each contract will have a specific expiration date on which the holder must exercise his or her option. The price quoted on an option is called the strike price. Options are often bought and sold through online or retail brokers.
Understanding Options
Options are flexible financial products. These contracts involve a buyer and a seller, with the buyer paying a premium for the rights granted by the contract. Call options allow the holder to buy an asset at a specific price within a specific time frame. A put, on the other hand, allows the holder to sell the asset at a specific price within a specific time frame. Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.
Traders and investors buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors use options to hedge or reduce the risk exposure of their portfolios.
In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option's daily volume and open interest are two key numbers to watch for in order to make the most informed investment decisions.
An American option can be exercised any time before the option's expiration date, while a European option can only be exercised on the expiration date or on the exercise date. Exercising means using the right to buy or sell the underlying security.
Special Considerations
Options contracts = 100 shares. Buyer pays premium fee per contract. Premium based on strike price and expiration date. Expiration date = deadline for contract usage. The asset determines the use-by date, which for stocks is typically the third Friday of the contract month.
Options Spreads
Option spreads are strategies that use a variety of combinations of buying and selling options to achieve a desired risk-return profile. Spreads are built using fixed options and can take advantage of different scenarios such as high or low volatility environments, moves up or down, or anything in between.
Advantages and Disadvantages of Options
Buying Call Options
As mentioned earlier, a call option that allows the holder to buy the underlying security at a stated strike price before the expiration date is known as expiration. The holder has no obligation to buy the asset if he does not want to buy the asset. Buyer's risk is limited to the premium paid. Movements in the underlying stock have no impact.
Buyers are bullish on a stock and believe that the stock price will exceed the strike price before the option expires. If the investor's bullish outlook materializes and the price rises above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the strike price above. current market to make a profit.
Their profit on this trade is the stock price minus the stock's strike price plus the option premium minus the premium and any brokerage commissions for executing the trade. The result is multiplied by the number of options contracts purchased, then multiplied by 100, assuming each contract represents 100 shares.
If the price of the underlying stock does not exceed the strike price on the expiration date, the option expires worthless. The holder is not required to purchase the shares but will forfeit the premium paid for the purchase.
Selling Call Options
Writing call options is called writing a contract. The writer receives the premium. In other words, the buyer pays a premium to the writer (or seller) of an option. The maximum profit is the premium received when selling the option. An investor sells a bearish call option and believes that the price of the underlying stock will fall or stay relatively close to the strike price of the option over the life of the option.
If the prevailing market action price is equal to or below the strike price at expiration, the option expires worthless to the buyer. The option seller pocket the premium as profit. The option is not exercised because the buyer will not buy the stock with a strike price greater than or equal to the prevailing market price.
However, if the stock's market price is higher than the strike price at expiration, the option seller must sell the stock to the option buyer at that lower strike price. In other words, the seller must either sell the stock from his or her portfolio or buy the stock at the prevailing market price in order to sell it back to the buyer of the call option. The contract drafters bear the loss. The size of the loss depends on the share price they must use to cover the buy order, plus brokerage fees, but minus any premium they receive.
As you can see, the risk to the call writer is much greater than the risk to the call buyer. The call buyer only takes the premium. The writer faces infinite risk as the stock price can continue to rise significantly, increasing the loss.
Buying Put Options
Put options are investments where the buyer believes that the market price of the underlying stock will fall below the strike price no later than the option's expiration date. Again, the holder can sell the shares without obligation to sell at the stated strike price per share on the stated date.
Because the buyer of the put option wants the stock price to fall, the put is profitable when the price of the underlying stock is below the strike price. If the prevailing market price is lower than the strike price at expiration, the investor can exercise the put option. They will sell the stock at the higher strike price of the option. If they want to replace holding these shares, they can buy them on the open market.
Their profit on this trade is the strike price minus the current market price, plus the cost minus premium and any brokerage commission for executing the trade. The result will be multiplied by the number of options contracts purchased, then multiplied by 100, assuming each contract represents 100 shares.
The value of holding a put will increase as the price of the underlying stock falls. Conversely, the value of a put option decreases as the stock price increases. The risk of buying a put is limited to losing the premium if the option expires worthless.
Selling Put Options
Selling put option is also known as entering into a contract. The writer of a put option believes that the price of the underlying stock will either stay the same or increase over the life of the option, making it bullish for the stock. Here, the option buyer has the right to force the seller to buy shares of the underlying asset at the strike price at expiration. If the price of the underlying stock closes above the strike price by the expiration date, the put option expires in vain. A writer's best interest is a bonus. The option is not exercised because the buyer of the option does not sell the stock at a lower strike price when the market price is high. If the market value of the shares falls below the strike price of the option, the seller must buy shares of the underlying stock at the strike price. In other words, a put option is exercised by the option buyer who sells the stock at the strike price because it is higher than the market value of the stock. The risk to the seller of a put option arises when the market price falls below the strike price. The seller must buy the stock at the strike price at expiration. Depending on how much the stock is depreciating, the writer's loss can be significant.
The seller (or seller) can either hold the stock and hope that the stock price will rise again above the purchase price, or sell the stock and incur a loss. Any losses are offset by the premium received.
Investors can sell a put option at the strike price if they believe the stock is valuable and are willing to buy it at that price. When the price declines and the buyer exercises the option, he or she receives the stock at the desired price with the added benefit of the option premium.
Gist
Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
Calls and puts form the basis of a wide range of options strategies designed for hedging, income or speculation.
While there are many opportunities to profit from options, investors should weigh the risks carefully.