Options, their types, and how they work.

Introduction

A call option is a derivative contract that gives the owner the right to buy or sell securities at an agreed-upon price within a specified time frame. If you’re a new investor, this can be a confusing concept. For more experienced investors, trading options can be very tempting, as it provides the opportunity to increase leverage on trades and apply industry knowledge and strategies at a high level.

Two Main Types of Options

There are two types of options. The first gives you the right to buy the asset, and the second gives you the right to sell it.

Call Option

The right to buy is known as a “call option.” A call option is “in the money” when the strike price is less than the underlying stock’s value. If you buy the option and sell the stock today, you will make a profit, provided that the sale price is higher than the price paid for the option.

You buy call options when you believe that the security will increase in value before the expiration date. If this happens, you will exercise the option. You will buy the security at the strike price and then sell it immediately at the higher market price. If you’re feeling optimistic, you may also wait to see if the price increases further. Buyers of call options are called “holders.”

Your profit will be the return of funds, after deducting the strike price and the commission for the call option. Transaction fees typically occur as well and should also be deducted. The intrinsic value of the option is the difference between the strike price and the current market price of the stock. If the price does not rise above the strike price, you will not exercise the option. Your loss will only be the amount paid for the option, even if the stock price drops to zero.

Why not just buy the security instead? Buying a call option gives you greater leverage.

Note: If the price rises, you may earn more profit than if you bought the security instead. Better yet, you only lose a fixed amount if the price drops. Thus, you can achieve a high return on a low investment.

The other advantage is that you can sell the option itself if the price rises. You can make money without having to pay for the security.

You can sell a call option if you believe that the asset price will rise. If it falls below the strike price, you will keep the value paid for the option. A seller of a call option is called a “writer.”

Put Option

With a “put option,” you buy the right to sell your shares at the strike price at any time until expiration. In other words, you have purchased the option to sell. A put option is “in the money” when the strike price is higher than the underlying stock’s value. Therefore, if you buy the option to sell and then purchase the stock today, you will make a profit, as your purchase price will be lower than the sale price.

Six Factors That Determine Option Prices

There are six factors that determine the price of an option:

1. The value of the underlying assets: The higher it is, the greater the value of the purchase conferred by the call option. Similarly, the higher the stock, the lower the value of selling it at a fixed price, as in the case of a put option.
2. Implied volatility: If traders believe that the price of the underlying asset will fluctuate significantly, the options become more valuable. Increased volatility raises the risk. As a result, traders demand higher returns for options.
3. Dividends: Call options usually lose their value before the expiration date, as the stock value decreases by the amount of dividends on the record date. The opposite typically occurs, where put option values may increase before the record date. The important note is that stock prices drop by the amount of the dividends, while the options themselves are unaffected.
4. Strike price: For calls, the lower the strike price, the greater the value due to its proximity to the current price (at the stock price) or in the money (below the stock price), meaning you can buy the underlying asset for less than the market price. For puts, the higher the strike price, the greater the value of the option, as you can sell the asset for more than the market price.
5. Expiration period

Time: The longer the time period, the higher the option’s value.

6. Interest Rates: Typically, call option prices rise with increasing interest rates, while put option prices decline as interest rates increase.

Why Trade Options?

Options offer you many advantages, but they come with high risks. The biggest advantage is that you do not own the underlying asset. You can benefit from the asset’s value, but you do not have to transport or store it. This is not a big deal for stocks, bonds, and currencies, but it may be
Source: https://www.thebalancemoney.com:443/options-definition-3305952

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