The two choices in options trading, and from which all types of options trades are built, are call options and put options. And there are two aspects, or “sides”, to an options trade; that of the buyer and the seller, or writer. Before we dive deeper into these, let’s refresh our understanding of what options are.
If you’ve ever wanted to learn how to trade options, you were probably overwhelmed at first. However, what if we told you it’s not too difficult to trade options once you learn the basics?
When you’re learning how to trade options, you need to build a sense of how to trade them and gain practical experience over time to become a successful options trader. That said, let’s start with the basics and learn the differences between call options and put options.
Understanding Options Basics and Terminology
It is imperative to first understand what options are themselves before we proceed further.
- An options contract is an option to buy or sell an underlying asset, which could be a stock, index, future or commodity. There is an expiry date associated with the contract before it may be exercised, if at all. Further, the option gives the bearer the right to buy or sell the underlying security but it is not necessary to exercise that right. It is a right and not an obligation.
- An equity option, or stock option contract, is simply a choice about whether you want to buy or sell shares of a stock at a specified price, on or before a specific date.
- As you will realize, trading options can be less risky than trading the stocks themselves provided this is done correctly.
- Another term to understand in the context of options trading is the ‘strike price’. This refers to the price at which you agree to buy or sell the underlying assets through the contract.
- The fee that is incurred in buying the options contract itself is referred to as the premium.
The Maximum Profits and Losses in Options Trading
There’s one crucial factor to take into account when trading options. If you buy an options contract, your maximum loss is limited to the amount of premium paid. However, you can in theory earn unlimited profits.
When you sell an option, it means you are selling the option but the profits will be restricted to the premium. When you sell, or write, an options contract, you receive a credit. However, when you write options, your loss can be theoretically unlimited (in a similar way that the profit of a straight call or put options trade is theoretically unlimited).
Now, let’s take a look at the differences between call options and put options.
Call Options vs. Put Options – Premiums
When you’re buying 1 call option or 1 put option, you pay a premium to receive the right to buy or sell 100 shares of the underlying stock, respectively. However, you’re not obligated to do so.
That said, the amount of premium you paid is the maximum amount you could lose. However, if your option expires in-the-money, you would automatically be exercised.
In order to receive the right, but not the obligation, to buy or sell the underlying stock at a specified price any time on or before the expiration date, the owner pays the seller, or writer, the options premium.
Let’s see how the mechanism works and how profits are made or losses incurred in options trading.
- If you buy a call option, and the underlying stock increases significantly, you could have significant profits. On the other hand, the trader of a put option would suffer.
- If you buy a put option, and the underlying stock falls significantly, you could have, once again, significant, potentially unlimited profits. In this case the trader of the call option would suffer.
For call options, remember to pay attention to the strike price. The lower this value, the more valuable your option will be. Conversely, in the case of put options, the higher the strike price of the contract, the more valuable the deal will be for you.
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Options Payoff Diagrams
Payoff diagrams are a great way to visualize the profits and losses associated with a strategy. The diagram is basically a visual representation of the outcomes. While the results of the strategy can be depicted in the diagrams at any point in time, the graph is usually used to depict results at expiration time.
While the Y-axis, called the vertical axis, represents the profits or losses, the X-axis, referred to as the horizontal axis, represents the price of the underlying asset.
Needless to say, options payoff diagrams are a valuable analysis tool when planning your options strategies. When you’re trading options, you need to know how your profit and loss will look like at expiration.
Here’s a look at the payoff diagram for call options.
Let us take a deeper look into the above options payoff diagram to understand what it is saying.
You will note the horizontal line passing through the middle of the diagram represents the horizontal axis. The payoff diagram clearly shows that the losses, shown below the horizontal axis, are capped at the premium paid (bottom left side of the diagram).
On the right side of the diagram, above the horizontal axis, are the profits, which, as you can see, are theoretically unlimited.
The point at which the curve meets the horizontal line is the break-even point at which neither profits nor losses are made.
Here’s a look at an example of a put option payoff diagram at expiration.
As you will see, loss here is incurred in the event of the rising prices of the underlying asset. However, the loss is capped. When the price of the underlying asset falls, as you can see in the left side of the graph above, the profits start coming in with an unlimited scope.
Here’s Why Writing Options is Risky
There are basically two sides to an options trade; the buyer (as in the case of trading call options or put options) and the seller (or writer). Now, the writer (seller) of an options contract takes the “opposite side” of risk and receives a premium. However, the writer is obligated to deliver shares of the security if they are exercised, or if the options contract expires in the money.
If you write options, you would receive a premium for taking on the risk. If you sell, or write, a call option, you are obligated to sell shares of the underlying stock. This happens when the call option holder exercises the option, or if the option expires in the money. In this case, the value of the underlying asset would have increased but you will be forced to sell it at a price as obligated by the contract. You would, therefore, be at a loss. The amount of the loss will depend on how high the price of the underlying asset changes.
If you write a put option, you are obligated to purchase shares of the underlying stock. This is if the put option expires in the money or the holder exercises the option. This time, you will have to purchase the underlying assets from the option holder at a price that is much higher than the market price. You will, once again, be at a loss which is theoretically unlimited.
There are two forms of call writing: naked writing and covered writing. Covered call writing is when a trader uses stocks which he owns himself when writing calls. In the case of naked call writing, you sell call options without first owning them yourself.
Writing naked options… risky business
Keep in mind that naked writing of options, or selling without hedging, is hazardous. You should not actually look to write or to sell options naked when you’re first starting out. Moreover, you’re going to need some collateral if you’re looking to write options in order to collect the premium.
It’s also important to have the right mindset and know when to trade options considering the market trends. If you are bullish on an asset, consider buying a call, and if you are bearish, a put option. This will enable you to make profits when the price of the underlying asset rises or falls, respectively.
When you’re learning how to trade options, you need to understand the basics first. We saw how an option is basically a contract which functions in the manner of a right without an obligation and must be used before a certain date. It is really important to consider the expiration date as it has a bearing on the trading strategy. It will also affect the risk and profit dynamics.
We saw how the potential loss is limited to the premium when buying options but when you write options, it can be very risky indeed. It is advisable to focus primarily on buying options when you’re first starting to learn how to trade options, or possibly by using a spread options trading strategy to help minimize, or spread, the risk of selling the option. A couple of Raging Bull’s services including Weekly Windfalls and Total Alpha excel in this strategy of being on the selling side of the options trade but in mitigating some of the inherent risk.
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