Options Trading are a type of derivative contract in which option holders have the right, but not the obligation, to buy or sell a security at a predetermined price in the future. Sellers of such a right charge option buyer an amount they refer to as a premium. Option holders will not exercise their right to exercise their option if market prices are unfavorable, thus ensuring that their potential losses do not exceed the premium. On the other hand, the market uses this right if it moves in a way that makes it more valuable.
Options contracts typically fall into two categories: “call” and “put.” With a call option, the buyer of the contract buys an option to buy the underlying resource in the future at a predetermined price, called the strike cost. The buyer of a put option acquires the right to sell the underlying asset at a predetermined price in the future.
Let’s look at some basic strategies that novice investors can use to reduce risk when trading calls or puts. The first two involve taking advantage of options to postpone the odds bet with a limited disadvantage if the bet goes badly. The rest involve adding hedging strategies to existing positions.
- Trading options can sound dangerous or complicated to novice financial backers, so they often shy away.
- Regardless, a few basic procedures using choices can help a budding financial backer protect their disadvantage and hedge market risk.
- Here we will explore four of these strategies: covered call, protective wander, long call, long call, and straddling.
- Options trading can be complicated, so make sure you know the risks and rewards before you start.
Buying Calls (Long Calls):
Options trading has certain advantages for market participants who want to place directional bets. You can buy a call option for less money than the asset itself if you expect its price to rise. Likewise, if the price instead falls, your losses will only be the premium you paid for the option. Traders who frequently use this strategy include:
They are “bullish” or bullish on a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk. You want to use leverage to take advantage of rising prices. Options are essentially leveraged instruments because they allow traders to increase the potential upside by smaller amounts than would be necessary to trade the underlying asset itself. Therefore, instead of spending $10,000 to buy 100 shares at $100, you can spend $2,000 on a call contract with a strike price that is 10% higher than the current market price.
100 shares of the underlying security are controlled by a standard stock option contract per share.
Let’s say a trader wants to invest $5,000 in Apple (AAPL), which is currently trading at around $165 per share. With this amount, they can buy 30 offers for $4,950. So let’s assume that the stock price increases by 10% to $181.50 over the next month. The trader’s portfolio will increase to $5,445, ignoring any transaction fees or brokerage commissions. As a result, the trader receives a net return on investment of $495 or 10%.
For now, let’s assume that a $165 stock option that expires in about a month costs $5.50 per share or $550 per contract. A trader can buy nine options for $4,950 considering his available investment budget. As the withdrawal contract checks 100 bids, the trader successfully closes 900 bids. If the stock price rises 10% to $181.50 at expiration, the option will be out-of-the-money (ITM) and valued at $16.50 per share (with a strike of $181.50 to $165) or $14,850 at 900 offers. Compared to trading the underlying asset directly, this represents a net dollar return of $9,990, or 200% of invested capital.
Risk versus reward:
The trader can only lose the premium paid for the long call. Since the option payout will increase with the price of the underlying asset until it expires, there is no limit to the amount of profit that can be made.
Buying Puts (Long Puts) Unlike a call option, a put option gives the holder the right to sell the underlying at a predetermined price before the contract expires. Traders who frequently use this method:
Are you bearish on a particular stock, ETF or index but want to take less risk than a short sale strategy? Want to take advantage of falling prices? Put options work exactly the opposite of call options, where the value of the put option increases as the price of the underlying decreases. The risk associated with a short position is unlimited, as there is theoretically no limit to how high the price can rise, despite the fact that short selling also allows traders to profit from price declines. If the underlying price rises above the strike price of the put option, the option simply becomes worthless.
Let’s say you think the cost per share is likely to drop from $60 to $50 or below given the terrible profit, but you’d rather not risk undervaluing the stock in case you’re off base. Instead, you can buy $50 for a $2.00 premium. In the event that the stock doesn’t drop below $50, or on the other hand, if it undoubtedly goes up, the most you will lose is the $2.00 premium.
Be that as it may, assuming you’re right and the stock falls to $45, you’d make $3 ($50 minus $45 minus the $2 fee).
Risk versus reward:
The premium paid for an option limits the amount of money that could be lost in a long wander. A put option uses the trader’s return, just like a long call option, but the underlying price cannot fall below zero, limiting the maximum profit from the position.
A covered call is a strategy that is added to an existing long position in the underlying asset, unlike long calls and long puts. It is essentially a potential profit call that is sold for an amount that would cover the current position size. The covered call writer maximizes the upside potential of the underlying position while collecting the option premium as income. This is a win-win situation for merchants who:
A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. If you are willing to limit your upside potential in exchange for some downside protection, you can expect the full option premium to be collected. At the time the broker sells the call, the option premium is collected, reducing the bid cost assumption and providing some security downside. Thus, by selling the option, the broker agrees to sell parts of the basis at the exercise price of the option, thereby covering the trader’s potential.