Many people seem to have a pretty good understanding of how the stock market works. However, very few seem to understand what buying and selling options entails. In fact, many people who trade stocks probably know very little about the options market.
With all that said, trading options can be a great way to hedge your risks while also making lucrative trades. And the more trading skills and experience you have in your arsenal, the more you’ll be able to set yourself up for success.
Are you interested in learning more? If you are, then continue reading and we’ll walk you through everything you need to know about buying and selling options.
Table of Contents
What Are Options?
Options are essentially contracts that give the owner the right to either sell or buy a certain amount of an underlying asset. The trader makes this trade on a date that’s already determined or they can do it before the contract expires. While they have the right to trade the asset, they’re not obliged to.
When you have a brokerage investment account, you can trade options like other asset classes.
Options are a great way to strengthen your portfolio. This is because options help provide you with leverage, protection, and more income.
Many people like to use options as a way to hedge against a stock market that’s declining so that they can limit their losses. You can also use options to bring in passive income.
Options as Derivatives
Options are considered to be under the umbrella of securities that are referred to as derivatives. The price of a derivative depends on the price of something else. Essentially, its price is derived from something.
Options are derived from financial securities. The value of an option will depend on the price of a different asset.
An example of a derivative can include a call, forward, put, future, and swap.
Put and Call Options
The reason why an option is derivative is due to the face that its price is linked to a different asset. If you purchase an options contract, then you’re being given the option (not the obligation) to sell or purchase an underlying asset at a determined price. You can purchase at that price no later than a pre-determined date.
When you have a call option in place, you have the ability to buy a stock. The opposite of a call is a put. A put option is when you have the right to sell a stock.
Why Use Options?
There are two main reasons why you would want to trade options. The first would be for speculation purposes. When you speculate, you’re basically betting on where a stock price is going to be at a later date.
If you think the price of a stock is going to go up, then you might buy the stock outright or purchase a call option for that stock. If you want to invest in a stock that costs $100, you’d be risking only a few dollars if you purchased a call option.
Another reason to trade options is for hedging. This means that you’re limiting your risk at a reasonable cost.
You can compare options to an insurance policy. Options basically insure your investments against a falling market.
Let’s say that you want to purchase healthcare stocks but also want to reduce your downside risk. If you used put options, you could limit your risk but still benefit from all of the upsides.
If you like to short stocks, then you can use call options to limit your losses. This is extremely helpful if you ever find yourself caught in a short squeeze.
How Do Options Work?
When it comes to figuring out the values of option contracts, it really comes down to figuring out the probabilities of future price movements. The more likely something will occur, the more expensive an option is going to be in order to profit from that event.
For example, a call option will go up as its underlying stock goes up.
The less time an option has until it expires, the less value that option’s going to have. This is because the more time there is between the purchase and expiration date of an option, the more movement it could make.
Because time is part of what’s used to price an option, a two-month option is going to be more valuable than a one-month option.
It should be noted that the same option strike that expires in one year is going to cost you more than the same strike for two months. This is because of time decay. If the price of the stock doesn’t change much, then the same option is going to have a lower value tomorrow than it has today.
Options are also something that you can always get better at. This is why it’s so important to never stop with your option trading education.
The Importance of Understanding Buying and Selling Options
As we can see, buying and selling options can become very lucrative. However, it can also be a bit complicated. This is why it’s so important to truly understand the fundamentals of trading options before you start executing trades.
Once you have that down, you can start limiting your risk while increasing your upside potential.
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