Options are derivative contracts that give the holder the right to buy or sell securities at an agreed price during a specified time period. If you are a new investor, this concept can be confusing. For more experienced investors, trading options can be very enticing, as they provide an opportunity to increase leverage in trading and apply industry knowledge and strategies at a high level.
Key Takeaways
“Call” and “put” options (to buy or sell assets respectively) give traders greater leverage than simply buying the asset outright. The pricing of options depends on many factors that reflect the performance of the underlying asset and the terms of the contract itself. Trading options is logistically complex and carries the risks of a highly competitive market and sophisticated investors. Options are traded on all kinds of securities (stocks, bonds, commodities) and currencies through several exchanges.
Definition of Options
To begin with, it’s important to understand what all the terms mean:
- Option: You pay a premium for the option or right to make the trade you want. You have no obligation to do so.
- Derivative: The option derives its value from the value of the underlying asset. This underlying value is one of the determinants of the option’s price.
- Agreed Price: Also known as the “strike price.” It does not change over time, regardless of what happens to the stock price. It’s called this because you will “strike” when the underlying value allows you to make a profit.
- Specified Period: This is the time until the agreed date, known as the “expiration date.” This is when your option expires. You can exercise your option at the strike price at any time until the expiration date. In Europe, you can only exercise it exactly on the expiration date.
The Two Main Types of Options
There are two types of options. The first gives you the right to buy the asset, and the other gives you the right to sell it.
Call Option
The right to buy is called a “call option” or simply “call.” A call option is “in the money” when the strike price is below the underlying stock value. If you buy the option and sell the stock today, you will make a profit, provided the selling price is higher than the premium paid for it.
You buy calls when you believe the asset will increase in value before the exercise date. If that happens, you will exercise the option. You will buy the asset at the strike price and then immediately sell it at the higher market price. If you are feeling optimistic, you may also wait to see if the price increases further. The buyer of call options is known as the “holder.”
Your profit equals the proceeds from the asset, after deducting the strike price and the premium 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 doesn’t rise above the strike price, you will not exercise the option. Your only loss will be the premium, even if the stock’s value drops to zero.
Why not just buy the asset instead? Buying a call option gives you greater leverage.
Note: If the price rises, you can make more money compared to just buying the asset outright. 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 asset.
You will sell a call option if you believe the asset price will go up. If it drops below the strike price, you will keep the premium. The seller of the call option is called the “writer.”
Put Option
With a “put option” or simply “put,” you buy the right to sell your stock at the strike price at any time until the expiration date. In other words, you purchased the option to sell it. A put option is “in the money” when the strike price is higher than the underlying stock value. Therefore, if you buy the option to sell and then buy the stock today, you will make a profit, as the purchase price will be less than the selling price.
Six
Factors Affecting Options Pricing
There are six factors that determine the price of an option:
- Underlying Asset Value: The higher it is, the greater the value of the buying option granted by a call option. Similarly, the higher the stock value, the less valuable the selling option at a fixed price becomes, as is the case with a put option.
- Implied Volatility: If traders believe that the price of the underlying asset will fluctuate significantly, then options become more valuable. Increased volatility raises the risk. Thus, traders demand higher returns for options.
- Earnings: Options lose value…
Source: https://www.thebalancemoney.com/options-definition-3305952
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