If you’re an investor, you must have heard about the options trading from fellow investors or news channels or other mediums. So let’s go through details on options trading.
What Is An Options Contract?
The options are a derivative contract, that allows investors to buy or sell, but not the obligation to buy or sell the underlying assets at a specific price and date. Underlying assets are usually securities like stocks, indexes, ETFs, currencies, or commodities.
An option contract gives investors the freedom, they do not require to buy or sell the underlying asset, unlike future contracts. Some investors use option as hedging purposes, some for trading or speculation purpose.
It is a little complex than another trading, but with a good opportunity and analysis, investors make lots of profit, that stocks, ETFs, the commodity can not match with similar amounts of investments. Options trading involves certain risks also.
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Types of Option Contracts
There are two types of options contracts, those call options (CE), and put options (PE).
The call options give its buyer the right, but not the obligation, to buy an underlying asset at a specified price within a specific time period. The underlying asset can be stocks, currencies, commodities, bonds, or ETFs.
The specific date is known as the expiry date and a specific price is known as the strike price. Generally, a trader buys a call option when they think the underlying asset price will appreciate.
The put options give its buyer the right, but not the obligation, to sell an underlying asset at a specified price within a specific time period. Stocks, currencies, commodities, bonds, ETFs can be the underlying asset for a put option.
The Put option will be exercised at the time expiry and the value changes with time and volatility.
What is Options Trading?
Buying and selling of call and put option contract is known as options trading. The option contracts are one of the most popular financial instruments, traded through a stock exchange.
How Options Trading Works?
Options contracts are generally like insurance and mostly used for hedging purposes. For example, you own a stock and market is going down or turn bear, so what you can do is buy a put option contract for that stock, if that stock falls, then you will get a higher return on the option contract that makes up the loss in the stock, in the way you can hold the stock longer.
Option pricing basically depends upon the underlying asset’s volatility and time left for the expiry. With lower volatility, the option contract tends to have a lower premium and vice versa. By day passing near the expiry option premium also decline due to the time value of money.
Benefits of Options Trading?
There are many benefits to option trading as it is a unique way to make money and save money.
Maximum Profit Minimum Loss
Suppose there is a stock priced at $500 and it has a lot size of 100 and you speculate stock price will go up to $550, then in order to buy a single lot of that stock, you need to pay $50,000, but if you buy a call option of $500 strike price then it would be priced at near about $10 or less or even more depending upon the volatility and time till expiry.
So you just have to invest only $1000 for that call option contract. If the price reaches the $550 point the call option value would be $50 or even more and if the stock stays right there or lower you will lose the maximum of $1000. So Call option allows you to gain maximum profit, but with limited loss.
Higher Potential Returns
As you know the option contracts need less money to invest, so you can buy a higher number of the option contract, if you compare it with a stock. In that way, if the market favors you, it is very easy to get higher returns.
The option is a very good hedging tool for all kinds of market and intelligent investors get most out of it. Investors generally prefer at the money option contract for hedging purposes.
Limitation Of Options Trading?
- Unlimited Loss: While buying an option has limited loss potential, selling an option may cause an unlimited loss as there is no upper limit for an underlying asset’s price.
- Liquidity: Out of the money option counters generally have very low liquidity and selling out of the money option contract at a proper valuation is quite difficult.
- Volatility: Option contracts are known for their volatility and controlling its volatility is quite difficult and investors may suffer huge losses because of that.
Options trading is quite profitable for some, and some face huge losses because of it. Understanding an option contract is quite important and new investors should invest in options contracts very carefully as its a double-headed sword.