When you learn about options trading, you will find that options traders use unique terms for the options markets. Understanding what terms like “strike price,” “exercise price,” and “expiration date” mean is crucial for effectively trading options. You will see these terms frequently, and understanding them has a significant impact on your chances of profiting from options trading.
Call and Put Options
You can buy or sell two different types of options: put options or call options. If you buy a put option, you have purchased the right, but not the obligation, to sell the underlying asset at an agreed-upon price. Call options work the other way around: they give you the right to buy the underlying asset at a specified price, but not the obligation.
Options are often used to hedge or limit risks in investments. For instance, suppose you want to buy a certain stock, but only if you believe the price will rise. In this case, you would buy a call option to secure the stock price and ensure that you can buy it for your portfolio before the price goes up.
You would buy a put option if you own the stock but want to ensure that you can sell it if the price drops below a certain level, so you don’t lose money. Options are often referred to as insurance contracts because they provide you with a certain level of protection against price fluctuations when used strategically in your investment portfolio.
Strike Price
The option seller sets the strike price for each option they sell; the seller is also known as the “option writer.” When buying a call option, the strike price is the price at which you can buy the underlying stock if you wish to exercise the option. For example, if you bought a call option with a strike price of $10, you have the right, but not the obligation, to buy those shares at $10, even if their price rises to over $10.
You can also sell the call option for a profit. Your profit is approximately the difference between the underlying stock price and the strike price.
When buying a put option, the strike price is the price at which you can sell the underlying asset. For example, if you bought a put option with a strike price of $10, you have the right to sell those shares at $10, even if their price is below $10.
You can also sell the put option for a profit. The profit is approximately the difference between the strike price and the underlying stock price. Like a call option, you can also exercise the option and sell or short the stock at $10, even if it is trading at $5 on the exchange.
Exercise Price
The option buyer pays a price called a “premium,” which is the cost of the option, for the right to buy or sell the underlying asset at the option’s strike price. If the buyer chooses to exercise this right, they are “exercising” the option. In other words, the exercise price of the option is synonymous with the strike price.
Exercising the option is beneficial if the underlying asset’s price is higher than the strike price for a call option, or if the underlying asset’s price is lower than the strike price for a put option.
Traders are not obligated to exercise the option, as it is not mandatory. You only exercise the option if you want to buy or sell the actual underlying asset. It’s important to note that most options are not exercised, even those that are profitable.
For example, suppose you bought a call option with a premium of $1 on a stock with a strike price of $10. Close to the option’s expiration date, the underlying stock is trading at $16. Instead of exercising the option and acquiring the stock at $10, the options trader would typically sell the option and close the trade. Thus, they achieve a net profit of about $5 for each share controlled.
Given that
Since one option controls 100 shares of stock, this trade achieves a net profit of $500. The calculation is as follows: the stock price of $16 minus the strike price of $10 means the option is worth about $6. The trader paid $1 for the option, so the profit is $5. The option price is about $6 because there are other factors that affect the value of the option besides the underlying stock price. These other factors are called “the Greeks,” represented by Greek letters.
Expiration Date of the Option
Option contracts set the expiration date as part of the contract specifications. For European-style options, the expiration date is the only date on which the profitable option can be exercised. This is because European-style options and positions cannot be exercised or closed before the expiration date.
For American-style options, the expiration date is the last date when the profitable option can be exercised. Options that are out-of-the-money (unprofitable) at expiration are not exercised and expire worthless.
For example, if you bought a call option with a strike price of $10, and the underlying stock is currently trading at $9 on the stock exchange, there is no reason to exercise those options; they have no value at expiration. Any premium paid for those options is lost.
Options traders who bought option contracts want their options to be in-the-money. Traders who sold (or wrote) option contracts want the buyer’s options to be out-of-the-money and expire worthless at expiration. When the buyer’s options expire worthless, it means the seller keeps the premium as profit for writing or selling the option.
What Options Are Best to Buy?
There is no specific methodology that can indicate the best options to buy or sell for every investor. Everyone has their own goals to maximize profit, minimize risk, and select securities that make sense for their investment purposes.
However, if you are looking for ideas on where to start your research, consider trading options on the most popular stocks. They will have plenty of volume (trading activity) and a lot of options trading activity. For example, Bank of America Corp (BAC), Meta (FB), formerly known as Facebook, and Micron Technology (MU) are three active stocks that trade over 100,000 options on them daily.
You can also choose stocks with expensive options, such as Amazon (AMZN) and Google (GOOGL), especially if you decide to sell them. This can bring you good income if the buyer does not exercise the options, or at least you can get the stock at a good price if the buyer exercises the options, depending on your strategy.
Naked Options
You can also buy options that are popular, with plenty of liquidity or trading activity, but only for stocks priced under $20. This works well if you decide to sell naked options, as it will not require you to have a large amount of margin available to buy the stock if the options are exercised.
Selling a naked option means writing or selling the option without holding a position in the underlying security. You will buy the option at a more favorable price, close the trade, and profit from the price difference for a gain. This higher-risk strategy theoretically has unlimited risk and is best used by experienced traders.
Frequently Asked Questions
Can you sell a call option before the stock price reaches the strike price?
As long as there are no restrictions on your account and sufficient funds are available, you can buy and sell options as you wish. You do not need to wait for the call option price to reach the strike price to sell the option.
How
Can the option be exercised?
You can exercise the option at any time from the moment of purchase until the expiration day. Your broker should offer this option alongside similar orders such as “Buy” and “Sell.” Make sure you have the purchasing power to cover the exercise. For example, if you have a call option with a strike price of $40, you will need $4000 to exercise the option.
What are Delta, Gamma, and Theta in options?
Delta, Gamma, and Theta are examples of options Greeks. These terms refer to the sensitivity
Source: https://www.thebalancemoney.com/options-strike-price-exercise-price-and-expiration-date-1031126
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