Most people know something about how investments like stocks, mutual funds and bonds work. Each is a type of security or tradable financial asset. Another type of security is options. Options represent an asset class that requires a certain amount of investor sophistication.
Once you understand the basics of options and how trading options works, you might want to learn more. You may even want to try your hand – eventually.
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Options are a form of derivative. “Derivative” simply means that its price is dependent on something else. For example, wine is a derivative of grapes. Ketchup is a derivative of tomatoes.
Options are derivatives of financial securities. The price and value of an option depends on the price of another asset. Another way to view the relationship between an option and its underlying asset is that an option is a contract that gives you the option (but not the obligation) to buy or sell shares of the underlying asset at a set price on or before a certain date.
Put And Call
Options come in two basic flavors – put option and call option. A put option is the right to sell an asset. A call option is the right to buy one. As a trader, you can purchase a call option to purchase a certain number of shares of a certain stock for a set price at any point in the next, let’s say 3 years. You could also purchase a put option to sell a certain number of shares of a stock for a set price at any point in the same period.
Each time you obtain a put or call option, you pay something called a premium for the right to buy or sell the stock. The premium is not refundable. You make money when you sell (exercise a put option) for more than the current value of the stock. Likewise, you can also make money by exercising your call option and buying a stock for less than its current value.
Both put and call options have an expiration date – a date past which you can’t buy or sell the underlying stock. If you let the expiration date pass without exercising your put or call, you lose your investment (the premium you paid).
On the other hand, the premium is less than the price of the underlying stock so even though you have lost, you haven’t lost as much as you might have if you bought or sold the stock at a loss.
Buyers And Sellers
If you purchase a call option, you are a buyer of an option to purchase an asset (stock) at a lower price than you can sell it for. If you own a put option you have bought on the theory that the asset (stock) will go down in value and you will be able to sell it for a higher price at a profit. Anyone who buys an option is called a holder.
Those who sell options are called writers (of options). As a holder (buyer) the most you can lose is the price you paid for the option. Writers (sellers) can lose much more than buyers because if you as a holder exercise your option, the writer must buy or sell, depending on the type of option you have.
Terms To Know
These are the basics of how the process of trading options works. Here are some terms used in options trading that can help you understand the process even more.
Strike Price – This is the price at which the underlying asset (stock) can be purchased or sold at. Remember, if you buy a call, you want the actual price to above the strike price so you can “buy low” and “sell high.” The reverse is true for a put.
Expiration Date – The exact date the options contract terminates.
In-The-Money – A call option is “in-the-money” if the current share price is above the strike price. A put option is “in-the-money” if the share price is lower than the strike price.
Out-Of-The-Money – You can probably guess that a call option is “out-of-the-money” if the current share price is below the strike price and opposite is true for a put option.
At-The-Money – When the share price is at or near the strike price for both a put or call option, it is considered “at-the-money.”
Premium – Total cost of a given options contract (put or call).
FinanceBoards offers many widgets dedicated to options trading and provides a range of historic and current data to help you understand the process better.