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A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Options Basics By Investopedia Share. The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises.
Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index.
This versatility, however, does not come without its costs. Options are complex securities. This is why, when trading options, you'll see a disclaimer like the following: Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss.
Only invest with risk capital. Option trading involves risk, especially if you don't know what you are doing. Because of this, many people suggest you steer clear of options and forget their existence.
On the other hand, being ignorant of any type of investment places you in a weak position. Without knowing about options you would not only forfeit having another item in your investing toolbox, you would also lose insight into the workings of some of the world's largest corporations. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.
This section will introduce you to the fundamentals of options. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase.
Unfortunately, you won't have the cash to buy it for another three months. Now, consider two theoretical situations that might arise: It's discovered that the house is actually the true birthplace of Elvis!
While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats has built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless.
Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives , which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.
Calls and Puts The two types of options are calls and puts. A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
Participants in the Options Market There are four types of participants in options markets depending on the position they take: Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of puts People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.
Here is the important distinction between buyers and sellers: They have the choice to exercise their rights. This means that a seller may be required to make good on a promise to buy or sell. Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.
The Lingo To trade options, you'll have to know the terminology associated with the options market. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock must go above for calls or go below for puts before a position can be exercised for a profit. All of this must occur before the expiration date.
These have fixed strike prices and expiration dates. Each listed option represents shares of company stock known as a contract. For call options, the option is said to be in-the-money if the share price is above the strike price.
A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost the price of an option is called the premium.
This price is determined by factors including the stock price, strike price, time remaining until expiration time value and volatility. Do you think options are over your head? Read Options And Futures: You Already Trade Them. Many people mistakenly believe that options are riskier investments than stocks.
This stems from the fact that most investors do not fully understand the concept of leverage. However, if used properly, options can have less risk than an equivalent position in a stock. Let's look at how to calculate the potential risk of stock and options positions and discover how options - and the power of leverage - can work in your favor.
Leverage has two basic definitions applicable to option trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into trouble. A dollar amount invested in a stock and the same dollar amount invested in an option do not equate to the same risk. To learn about how leverage works with a different type of investment, read Leveraged ETFs: The second definition characterizes leverage as maintaining the same sized position but spending less money doing so.
This is the definition of leverage that a consistently successful trader incorporates into his or her frame of reference. This is the definition that investors must now understand and embrace.
It is easy to see the obvious disparity here and our greed always is seeking a higher potential for profit. Unfortunately, most investors can't see past that. The problem is that there is another disparity here beyond the obvious difference in the numbers of shares an investor can control: This disparity is not so easily seen by investors blinded by greed.
For more insight, see Trading A Stock Vs. Stock Options - Part 1 and Part 2. In the example above, the option trade has much more compared to the stock trade. With the stock trade, your entire investment can be lost, but only with an improbable movement in the stock. In the option trade, however, you stand to lose your entire investment if the stock simply trades down to the long option's strike price. For example, if you own the 40 strike an in-the-money option , the stock only will need to trade below 40 by expiration for the entire investment to be lost.
Clearly, there is a large risk disparity between owning the same dollar amount of stocks or options. This risk disparity exists because the proper definition of leverage was applied incorrectly to the situation. To correct this problem, let's go over two alternative ways to balance risk disparity while keeping the positions equally profitable.More...