Introduction
Options are among the most popular trading vehicles because their price can vary quickly, allowing traders to make (or lose) a lot of money quickly. Options strategies can be simple or sophisticated, with a wide range of payoffs and occasionally strange names. (Does anyone remember the Iron Condor?)
Options are conditional derivative contracts that allow option holders to buy or sell a security at a predetermined price. Option buyers are charged a “premium” by the sellers in exchange for such a right.
If market prices are unfavourable, option holders will let the option expire worthless, guaranteeing that their losses do not exceed the premium. Option sellers (option writers), on the other hand, take on more risk than option purchasers, which is why they want a higher premium.
There are two types of options: “call” and “place.” A call option gives the contract buyer the right to buy the underlying asset at a fixed price in the future, known as the exercise price or strike price. A put option gives the buyer all the rights to sell the underlying asset at a predetermined price in the future.
All options strategies, regardless of their intricacy, are based on two basic types of options: call and put. Five popular techniques are shown below, along with a summary of their reward and risk, as well as when a trader might apply them. While these methods are simple, they have the potential to make a trader a lot of money – but they are not without danger.
1. A long phone call
The trader buys a call – referred to as “going long” a call – with the expectation that the stock price will exceed the strike price by the expiration date. If the stock soars, the upside on this strategy is unbounded, and traders can profit many times their initial investment.
2. Covered Call
A covered call is similar to selling a call option but with a twist. In this case, the trader sells a call while also purchasing 100 shares of the stock underlying the option.
By owning the stock, you may turn a potentially risky investment – a short call – into a relatively safe and profitable one. At expiration, traders expect the stock price to be lower than the strike price. The owner should sell the stock to the call buyer at the decided strike price if the stock ends above the strike price.
Assume a trader purchases 1,000 shares of BP (BP) at $44 per share and simultaneously writes 10 call options (one contract for every 100 shares) with a strike price of $46 expiring in one month for $0.25 per share, or $25 per contract and $250 total for the ten contracts. The $0.25 premium lowers the stock's cost basis to $43.75,As a result, any decline in the underlying up to this time will be offset by the premium earned from the option position, providing very minimal downside protection.
3. Extensive use
The trader buys a put – “going long” a put – with the expectation that the stock price will be below the strike price by expiration. If the price falls dramatically, the profit on this transaction could be many times the initial investment.
4. Briefly stated
This strategy is the inverse of the long put, in which the trader sells a put (also known as “going short” a put) and anticipates the stock price to rise above the strike price by the expiration date.
The trader earns a cash premium in exchange for selling a put, which is the highest a short put may earn. The trader must buy the shares at the strike price if the stock closes below the strike price at option expiration.
5. Married Put
This approach is similar to the long put, but with a difference. The trader buys a put and owns the underlying stock. This is a hedging transaction, in which the trader expects the stock to gain but needs “insurance” in case it drops. If the stock does fall, then the long put will compensate for the loss.
6.Purchasing Puts (Long Put)
This is the strategy of choice for traders who:
Are negative on a specific company, ETF, or index but don't want to take on the danger of short-selling?
Want to take advantage of lower prices by using leverage
A put option works exactly the opposite way as a call option, with the put option increasing in value when the underlying price declines. While short-selling allows a trader to profit from decreasing prices, the risk associated with a short position is unbounded because there is no theoretical limit to how high a price can increase.
Why should you trade options instead of a direct asset?
Trading options has a number of advantages. (CBOE) Chicago board of options exchange is the world's largest options exchange, including options on a wide range of individual equities, ETFs, and indexes. Traders can create option strategies that range from buying or selling a single option to multi-option strategies that involve many options trading at the same time.
Conclusion
Options provide investors with different ways of profiting from underlying securities trading. Different combinations of options, underlying assets, and other derivatives are used in a variety of strategies. Buying calls, buying puts, selling covered calls, and buying protective puts are all basic techniques for novices.
Trading options rather than underlying assets has some advantages, such as downside protection and leveraged gains, but it also has some drawbacks, such as the obligation to pay a premium upfront. Choosing a broker is the fundamental step in trading options.
