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- Essential Options Trading Guide
- Outdoor Patio Flooring that Offers the Best Return on Investment
- More Advice on Home Improvements and Return on Investment
- 12 Best Safe Investment Options in India
- Best Low Risk Investments for High Return
Options trading may seem overwhelming, but they're easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes.
Essential Options Trading Guide
These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot. Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires.
Options can be purchased like most other asset classes with brokerage investment accounts. They do this through added income, protection, and even leverage. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:. Options involve risks and are not suitable for everyone.
Options trading can be speculative in nature and carry substantial risk of loss. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset.
An option is a derivative because its price is intrinsically linked to the price of something else.
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Think of a call option as a down-payment for a future purpose. A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.
The potential home buyer would benefit from the option of buying or not. Well, they can—you know it as a non-refundable deposit. The potential home buyer needs to contribute a down-payment to lock in that right.
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It is the price of the option contract. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired.
Now, think of a put option as an insurance policy. The policy has a face value and gives the insurance holder protection in the event the home is damaged. What if, instead of a home, your asset was a stock or index investment? Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock.
Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock.
Keeping these four scenarios straight is crucial. Here is the important distinction between holders and writers:. Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis.
A speculator might buy the stock or buy a call option on the stock. Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way.
In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events.
The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock underlying goes up. This is the key to understanding the relative value of options. The less time there is until expiry, the less value an option will have.
Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa. Accordingly, the same option strike that expires in a year will cost more than the same strike for one month.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down.
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Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
On most U. The majority of the time, holders choose to take their profits by trading out closing out their position. This means that option holders sell their options in the market, and writers buy their positions back to close. Time value represents the added value an investor has to pay for an option above the intrinsic value.
So, the price of the option in our example can be thought of as the following:. In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely. The distinction between American and European options has nothing to do with geography, only with early exercise.
Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium. Or they can become totally different products all together with "optionality" embedded in them.
Again, exotic options are typically for professional derivatives traders. Options can also be categorized by their duration. Short-term options are those that expire generally within a year. LEAPS are identical to regular options, they just have longer durations. Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis.
Index and ETF options also sometimes offer quarterly expiries. More and more traders are finding option data through online sources. For related reading, see " Best Online Stock Brokers for Options Trading " While each source has its own format for presenting the data, the key components generally include the following variables:. This position profits if the price of the underlying rises falls , and your downside is limited to loss of the option premium spent.
You would enter this strategy if you expect a large move in the stock but are not sure which direction. Basically, you need the stock to have a move outside of a range. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle. Spreads use two or more options positions of the same class.
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They combine having a market opinion speculation with limiting losses hedging. Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but a different strike.
The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Combinations are trades constructed with both a call and a put.
Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of buy one, sell two, buy one. If this ratio does not hold, it is not a butterfly.