A widely misconstrued asset class is that of options. There’s an actual reason behind the perception of options as being rather mysterious. Trading in options works out as an exercise in complications. If you can get a measure of understanding into how options are traded, and how to turn methods of options trading in your favour, then you’ve shown your mettle.
What are options?
Options are contracts allowing investors to buy/sell a certain asset at a predetermined price, over a certain time period. The underlying asset could be an index, ETF, security, or community. Investors have the option to buy/sell when the contract runs out, but need not do so – hence the name.
Depending on if you are selling/buying, there are two types of options: call options, and put options.
As a stock rises, call options increase in value. These instruments permit the owner to lock in a price. The aim here is to purchase a specific stock by a certain date. Call options are popular because, responding to a minor increase in the stock price, they appreciate quickly.
How does the Call Option work?
A call option lets you buy a stock at a strike price by a specific date. The call buyer will pay a premium for this entitlement. The call seller will obtain this premium. An option ceases to exist after expiration.
Each contract is 100 shares of the underlying stock, an option being a contract. Option prices are measured in per-share price.
How is a call option sold?
There’s a call sold for each one that is bought. The payoff structure is a mirror image of that for buying a call. Stocks either remain flat or decline. In that event, call sellers earn the premium without complications.
What are put options?
As a stock plunges, put options experience an inversely proportional increase in value.
How do put options work?
You are entitled to a put option to sell a stock at the strike price. This occurs at the option’s expiration. In this case, the put buyer recompenses the seller by way of a premium. An option always is settled post-expiration.
Put options are profitable when, at expiration, the stock price is below the strike price.
Could buying a put option be profitable?
It is to magnify the profit from a stock’s decline that investors purchase a put option. You may profit from stock below the strike price, till the time the option ends in expiration.
By buying puts, you insure yourself against stock decline.
What are the benefits of selling a put option?
Put sellers’ payoff is the mirror image of those applicable for buyers. When the stock appreciates above the strike price by expiration, the put seller is in profit. The gain is capped at the premium obtained.
Options trading strategies
Long call
The trader purchases a call and expects the stock price to appreciate over and above the strike price at the time of expiration. In case the stock soars, you may make a profit many times over your investment.
What is the best time to use a long call?
When the investor expects the stock to experience a major appreciation, then is the appropriate time to use a long call. In case the stock appreciates a tad bit above stock price, the option may yet be profitable. However, this may not even recover the premium and you may incur a net loss.
Covered call
‘Going short’ on a call option is what a covered call is about. Not only do you buy the stock underlying the option, you also sell the call. By owning the stock, you can turn the short call into a safe income-generating trade.
When is the best time to use a covered call?
A covered call can convert your existing holding into cash. It is in the case of taxes on the premium and capital gains upon a stock being called, that the covered call is extremely useful regarding tax-advantaged accounts.
Long put
Going long with reference to a put (buying it), the trader predicts the stock price to be situated below the strike price by expiration. In the event of the stock crashing, profit on such trading can be proportionately many times the initial investment.
When is the best time to use a long put?
When you expect the stock to depreciate considerably before option expiry, the long put is a good instrument. The option may be profitable when the stock depreciates a tad bit below strike price.
Short put
Going short with respect to a put (selling a put), you may well expect the stock price to be situated above the strike price by expiration. There’s a cash premium received for the selling of a put. When the stock rests below the strike price, the trader will be persuaded to buy it at the strike price.
Short put profit never surpasses the premium received.
When is the best time to use a short put?
When you anticipate the stock to appreciate the above the strike price by expiration, then is the right time to use the short put. You will be permitted to have all of the premium received, the reason being the requirement of the stock to be situated only at or a tad bit above the strike price, causing the option’s expiry.
When the stock is put to you, the broker will confirm you have sufficient equity in your account to purchase the stock. If the outcome is expected to be profitable, many traders will ensure there’s enough cash with them to purchase the stock.
Conclusion
You as the trader have to work on a number of concepts to ensure your deployment of option trading strategies is not underwhelming. You are quite capable of ratcheting up the level of planning, in order for your portfolio to be profitable. We advise you to tighten your belt and start working well in advance with the methods of options trading. Options are an asset class that definitely rewards careful hard work.
