Beginners Guide To Stock Options

Beginners Guide To Stock Options – Options are a form of derivative contract that gives the buyers of the contracts (option holders) the right (but not the obligation) to buy or sell a security at a chosen price at some point in the future. Option buyers are charged an amount called a premium by the sellers for such a right. Should market prices be unfavorable to the option holders, they will allow the option to expire worthless and not exercise this right, ensuring that potential losses are not greater than the premium. On the other hand, if the market moves in the direction that makes this right more valuable, it exploits it.

Options are generally divided into “call” and “put” contracts. With a call option, the buyer of the contract buys the right to

Beginners Guide To Stock Options

The underlying asset in the future at a predetermined price, called the strike price or strike price. With a put option, the buyer acquires the right to

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Let’s take a look at some basic strategies that a novice investor can use with calls or puts to limit their risk. The first two involve using options to place a directional bet with a limited downside if the bet goes wrong. The others involve hedging strategies that are layered on top of existing positions.

There are some advantages to trading options for those who want to make a targeted investment in the market. If you think the price of an asset will rise, you can buy a call option with less capital than the asset itself. Meanwhile, if the price instead falls, your losses are limited to the premium paid for the options and no more. This may be a preferred strategy for traders who:

Options are essentially instruments of leverage because they allow traders to amplify the potential upside by using smaller amounts than would otherwise be required if trading the underlying asset itself. So instead of laying out $10,000 to buy 100 shares of a $100 stock, you could hypothetically spend, say, $2,000 on a call contract with a strike price 10% higher than the current market price.

Suppose atrader wants to invest $5,000 in Apple (AAPL), which is trading at about $165 per share. With this amount, they can buy 30 shares for $4,950. Then assume that the stock price increases by 10% to $181.50 over the next month. Ignoring any brokerage or transaction fees, the trader’s portfolio will rise to $5,445, giving the trader a net return in dollars of $495, or 10% on invested capital.

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Now let’s say that a call option on the stock with a strike price of $165 expiring about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, they can buy nine options for a cost of $4,950. Since the options contract controls 100 shares, the trader is effectively trading 900 shares. If the stock price increases by 10% to $181.50 at expiration, the option will expire in the money (ITM) and be worth $16.50 per share (for a strike of $181.50 to $165), or $14,850 of 900 shares. That’s a return of $9,990 or 200% on the capital invested, a much greater return compared to trading the underlying asset directly.

The trader’s potential loss from a long call is limited to the premium paid. The potential profit is unlimited because the option’s profit will increase along with the underlying asset price until it expires, and there is theoretically no limit to how high it can go.

If a call option gives the holder the right to buy the underlying at a fixed price before the contract expires, a put option gives the holder the right to

A put option effectively works in the exact opposite direction from how a call option does, where the put option gains value when the price of the underlying falls. Although shorting also allows a trader to profit from falling prices, the risk of a short position is unlimited because there is theoretically no limit to how high a price can rise. With a put option, if the underlying ends up higher than the option’s strike price, the option will simply expire worthless.

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Say you think the price of a stock is likely to drop from $60 to $50 or lower based on poor earnings, but you don’t want to risk selling the stock short if you’re wrong. Instead, you can buy $50 for a $2.00 premium. If the stock doesn’t fall below $50, or if it really goes up, the most you’ll lose is the $2.00 premium.

But if you’re right and the stock drops all the way to $45, you’d make $3 ($50 minus $45. minus the $2 premium).

The potential loss on a long put is limited to the premium paid for the options. The maximum profit from the position is limited because the underlying price cannot fall below zero, but as with a long call option, the put option takes advantage of the trader’s return.

Unlike a long call or long put, a covered call is a strategy that is superimposed on an existing long position in the underlying asset. It is essentially an upside call that is sold in an amount that would cover the existing position size. In this way, the covered call writer collects the option premium as income, but also limits the upside potential of the underlying position. This is a preferred position for traders who:

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A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option’s premium is collected, lowering the cost basis of the shares and providing some downside protection. In return, by selling the option, the trader agrees to sell shares of the underlying at the option’s strike price, thereby limiting the trader’s upside potential.

Suppose a trader buys 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, at a cost of 0, $25 per share, or $25 per share. contract and $250 total for the 10 contracts. The $0.25 premium reduces the cost basis of the shares to $43.75, so any decline in the underlying down to this point will be offset by the premium received from the option position, providing limited downside protection.

If the stock price rises above $46 before expiration, the short call option will be exercised (or “called”), meaning the trader must deliver the stock at the option’s strike price. In this case, the trader will make a profit of $2.25 per share ($46 strike price – $43.75 cost basis).

However, this example suggests that the trader does not expect BP to go above $46 or significantly below $44 in the next month. As long as the stock does not rise above $46 and get called before the options expire, the trader will keep the premium free and clear and can continue to sell calls against the stock if desired.

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If the stock price rises above the strike price before expiration, the short call option can be exercised and the trader must deliver shares of the underlying at the option’s strike price, even if it is below the market price. In exchange for this risk, a covered call strategy provides limited downside protection in the form of the premium received when selling the call option.

A protective put involves buying a downside amount to cover an existing position in the underlying asset. In effect, this strategy sets a lower floor below which you cannot lose more. Of course, you will have to pay for the option’s premium. In this way, it acts as a kind of insurance against losses. This is a preferred strategy for traders who own the underlying asset and want protection on the downside

Thus, a protective put is a long put, like the strategy we discussed above; however, the goal is, as the name suggests, protection on the downside versus trying to capitalize on a downside move. If a trader owns stocks with long-term bullish sentiment but wants to protect against a short-term decline, they can buy a protective put.

If the price of the underlying increases and is above the ask price at expiration, the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price. On the other hand, if the underlying price declines, the trader’s portfolio position loses value, but this loss is largely covered by the profit from the put option position. Therefore, the position can effectively be seen as an insurance strategy.

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The trader can set the strike price below the current price to reduce the premium payment at the expense of reduced downside protection. This can be seen as excess insurance. For example, suppose an investor buys 1,000 shares of Coca-Cola (KO) at a price of $44 and wants to protect the investment from adverse price movements over the next two months. The following put options are available:

The table shows that the cost of protection increases with the level of this. For example, if