What are options and how do they work? Here’s a good introduction about options and how to trade them.
Before we answer the question of how do options work, we want to first introduce you to what options are, why they’re needed, and why it is essential to know about them.
Options offer the trader some unique advantages and are undoubtedly a great way to enhance your portfolio. They can also help you to mitigate losses in the stock market. That said, they carry significant risks too as we shall explain later in this article.
Options trading is an exciting field and you can quickly get started once you master the basics. It’s a lot easier than you would think!
What Are Options? Getting to Know The Key Terminology
At the core of options are specially designed contracts. An option is a contract that gives the bearer a right to purchase or sell an underlying asset at a pre-determined price up until a specified period. This information must be committed to memory. There is generally no obligation on the part of the options bearer to buy or sell anything unless he desires so.
The price at which this asset is either purchased or sold is called the strike price. You will find that there are several options available at strike prices both exceeding the current stock price and below it.
The term “premium” refers to the option’s price itself. Some factors can govern the total cost associated with the contract. The major factors include the amount of time remaining until the option expires, the current stock price, volatility, and the strike price itself.
How Do Options Work: Understanding Call and Put Options
Now that you know what are options, let’s proceed further with understanding call and put options. These naturally follow, in fact, from the very definition of options. How do options work really? It’s imperative for you to understand what are call and put options first.
A call option gives the bearer the right to buy the underlying asset at the agreed strike price within a particular period. On the other hand, a put option allows the holder the right to sell the underlying asset at the strike price within the agreed timeframe.
The great thing is that there are generally no margin requirements to be met if you wish to purchase an options contract. The reason is quite evident, in fact: your risk is limited in this case. The maximal losses a call or put options bearer can incur equal the premium itself.
You can buy a call option when you consider that the market is bullish and that the price of the shares will rise significantly above the strike price. This has to happen before the contract expires, in any case. If the stock price does increase and surpasses the strike price, you can immediately exercise your option and purchase the stock at the strike price which is lower than the current stock price. You can then sell your stock and earn massive profits.
You can also choose to sell the call options contract before the expiry date and again realize a profit without having to exercise your right to buy the stock.
What if the price does not increase as anticipated? In that case, you can let your call option expire without exercising it. You only lose an amount equalling your premium. You can also try to sell the call option before the expiry date with the purpose of taking a smaller loss on the position.
Similarly, if you are bearish on a stock and think that its price is about to fall soon, you could consider buying a put option. Later, when the stock price does fall below the strike price, you can exercise the put option and sell your stock at the (higher) strike price, earning profits.
Alternatively you can also choose to sell the put options contract before the expiry date and again realize a profit without having to exercise your right to buy the stock.
You can also read this resource on call and put options to better understand trading options better.
The Advantages of Buying Options
Options present some compelling advantages, and we’ve highlighted some of these here.
- High Profits: As we saw in the earlier section, you can buy call options when you are bullish on an asset or purchase put options when you are bearish on the same. If the market moves as anticipated, you can end up making large profits.
- Limited Losses: The main reason for using call or put options are that the maximum loss is limited to the premium you paid. If you buy a call option and the price of the underlying asset does not increase, you are not obligated to buy the asset at all. You can allow the contract to expire by itself.
- Low Risk: Options are often used to lower risks when trading. For instance, if you purchase a put option, you have an insurance mechanism in place wherein you can attempt to sell the underlying options contract at the strike price even if it is much higher than the current market price .
- Reduced Costs: You can save on the costs when buying an option as compared to directly buying the stock directly.
The Disadvantages of Buying and Selling Options
The disadvantages of trading options are:
- Upfront Payment: You will immediately realize that an upfront cost needs to be deposited in the form of the premium when you buy an option.
- Commissions: Higher commissions can cause issues for many options traders. The commission rates are typically higher for options. This can mean that you can lose out on some of your profits.
- Limited Availability: Although you will find options for many stocks, they are not available for all of them and this can come as a disadvantage for some options traders as well.
- Time: It is essential to consider the implications of the expiration date when you trade an option. As the expiration date draws closer, the option loses its value due to time decay. This is understandable as the deadline to make profits arrives closer.
The disadvantages of options can be even more severe for options sellers.
The options writer (seller) receives a premium but can face the risk of unlimited losses. Let’s say that you sell a call option ( a trader in this case is buying a put option) but the price of the underlying asset ends up decreasing. You will now be obligated to sell shares to the options bearer at the promised (and lower) strike price.
Similar is the case with the one selling a put option. If the price of the asset increases, you end up having to buy shares from the bearer at a much higher price. In any case, the maximum profit of the options seller is limited to the premium itself.
Options Trading Strategies You Should Remember
Now that you know what options are and how they work, let us discuss the best possible way in which you can use them to make profits. In essence, if you are bullish on a particular stock, it may best to buy a call option.
This will help you make profits while minimizing the risk. For a long call, your maximal loss will be limited to the premium you have paid. Your potential profit, however, will be unlimited if the underlying stock price can keep rising.
Let’s tackle the opposite scenario. What if you’re bearish on a stock? Let’s say you would also not like to go the short-selling route, to help prevent possible significant losses. How can you do that while still making a profit from the anticipated falling prices? You buy a put option. Once again, your potential loss is limited to the premium you paid.
There are several options strategies in existence. Consider the bear put spread, which involves the trader buying a put option and simultaneously selling a put option on the same asset but at a lower strike price. Both the puts share the same expiration date.
As you can guess, this strategy allows you to reduce the cost you need to deposit upfront in purchasing a put option when you’re bearish on an individual asset.
In contrast, a bull call spread involves purchasing a call option and at the same time, selling a call option at a strike price that is higher than the first. This can be another type of bullish trade strategy if you believe that a stock will move up.
The Bottom Line
Options are very flexible tools and hold the promise of massive returns to traders while also minimizing losses when used properly. There are a multitude of different options strategies that can be utilized depending on the anticipated price moves.
Ensure that you understand the nuances of buying and selling options before you begin trading. We recommend that you check out this article which talks about a number of great options strategies that you can learn from and use in your trading regime.
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