Buying And Selling Stocks And Shares For Beginners – Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investors’ portfolios are often constructed with a variety of asset classes. These can be stocks, bonds, ETFs and even mutual funds.
Options are another asset class that, when used properly, offer many advantages that stocks and ETFs alone cannot.
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Options are contracts that give the holder the right (but not the obligation) to buy or sell an amount of an underlying asset at a predetermined price before the contract expires. Like most other asset classes, options can be purchased with brokerage investment accounts.
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Options are powerful because they can improve a person’s portfolio. They do this through additional income, protection and even leverage. Depending on the situation, there is usually an option scenario that is right for an investor’s goal. A popular example would be using options as an effective hedge against a falling stock market to limit downside losses. In fact, options were invented for hedging purposes. Hedging with options is all about reducing risk at a reasonable cost. Here, we can think of using options like insurance policy. Just like insuring your home or car, options can be used to insure your investments against a downturn.
Imagine you want to buy tech stocks, but you also want to limit your losses. By using put options, you can limit your downside risk and profitably enjoy all the upside. For short sellers, call options can be used to limit losses if the underlying price moves against their trade, especially in a short squeeze.
Options can also be used for speculation. Speculation is a bet on the direction of future prices. A speculator may think that the price of a stock will rise, perhaps based on fundamental analysis or technical analysis. A speculator can buy stocks or buy a call option on the stock. Speculating with a call option – rather than buying the stock outright – is attractive to some traders because the option provides leverage. An out-of-the-money call option will only cost a few dollars or a few cents compared to the full price of a $100 stock.
Options belong to a larger group of securities known as derivatives. The price of a derivative is dependent on the price of something else. Options are derivatives of financial securities; their value depends on the price of other assets. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities.
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Valuing options contracts is essentially about determining the probabilities of future price events. The more likely something is to happen, the more expensive the opportunity to profit from that event would be. For example, the call value goes up as the stock (the underlying) goes up. This is the key to understanding the relative value of options.
The less time until expiration, the less valuable an option will be. This is because the chances of the underlying stock price changing decreases as it approaches expiration. Therefore, an opportunity is wasted. If you buy an out-of-the-money one-month option and the stock doesn’t move, the option will become less valuable each day. Since time is a component of an option’s price, a one-month option will be worth less than a three-month option. That is, as more time is available, the probability of a price movement in your favor increases, and vice versa.
Accordingly, the same option strike that expires in one year will cost more than the same strike in one month. This characteristic waste of opportunity is a consequence of the decay of time. The same option will be worth less tomorrow than it is today if the stock price does not move.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price changes increase the chances of significant up and down moves. A larger price change will increase the chances of an event occurring. So, the higher the volatility, the higher the option price. Options trading and volatility are related to each other in this way.
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On most US exchanges, a stock option contract is an option to buy or sell 100 shares; therefore, you must multiply the contract premium by 100 to get the total amount you will need to spend to buy the call.
In most cases, holders choose to take their profits by trading out (closing) their position. This means that option owners sell their options in the market and writers buy them to re-close their positions. Only about 10% of options are exercised, 60% are traded (excluded) and 30% expire worthless.
Option price fluctuations can be explained by intrinsic value and extrinsic value, also known as time value. An option’s premium is a combination of its intrinsic value and time value. The intrinsic value is the amount in the money of an option contract, which for a call option is the amount above the strike price at which the stock is trading. Time value represents the added value an investor must pay for an option over its intrinsic value. This is the external value or time value. So the option price in our example can be thought of as:
In real life, options are almost always traded at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is extremely unlikely.
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Options are a type of derivative security. An option is a derivative because its price is inherently linked to the price of something else. If you buy an option contract, it gives you the right, but not the obligation, to buy or sell an underlying asset at a fixed price on or before a certain date.
Acall option gives the holder the right to buy a share and aput option gives the holder the right to sell a share. Think of a call option as payment for a future purchase.
The options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry a high risk of loss.
A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before the expiration date. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).
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A long call can be used to speculate on the rising price of the underlying, as it has unlimited upside potential, but the maximum loss is the premium (price) paid for the option.
A potential home sees a new development. This person wants the right to buy a house in the future, but he will only want to use this right after some urbanizations have been built around the area.
A potential home buyer would either take advantage of the option to purchase or not. Imagine that they can buy the developer’s call option to buy the house for $400,000 at any time in the next three years. Well, they can, you know it as a non-refundable deposit. Of course, the developer wouldn’t give this option away for free. A potential home buyer must provide a down payment to lock in this right.
For an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays to the developer. Let’s say that two years have passed, and now the urbanization has been built and the zoning has been approved. The home buyer exercises the option and buys the home for $400,000 because it is a contract purchase.
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The market value of that home may have doubled to $800,000. But because the payment is locked in at a predetermined price, the buyer pays $400,000. Now, in another scenario, say zoning approval doesn’t come until next year. four One year has passed since this opportunity ended. Now the home buyer has to pay the market price, because the contract has expired. In either case, the developer collects the original $20,000.
Unlike call options, a put gives the holder the right, but not the obligation, to sell the underlying stock at the strike price on or before the expiration date. A long put is therefore a short position in the underlying security, as puts gain value as the underlying price falls (they have a negative delta). Hedging positions can be purchased as a form of insurance, providing investors with a price floor to cover their positions.
Now, think of a put option as an insurance policy. If you own your home, you’re probably familiar with the process of purchasing home insurance. A homeowner purchases a homeowner’s policy to protect their home from damage. They pay an amount called premium for a certain period of time, say a year. The policy has a nominal value and provides protection to the policyholder in the event of damage to the home.
What if, instead of a home, your asset was a stock or index investment? Likewise, if an investor wants insurance on their S&P 500