Options trading is known as one of the most popular modes of investment. But most of the traders lose in this kind of trading because of severe gaps in understanding and know-how of its derivatives.
So, we recommend you never execute an option trade without sufficient knowledge. In this post, we have discussed all an investor must know about the options, their types, and some common strategies.
What is Options Trading?
Options are basically contracts of trade that investors use to take risks about whether an asset price will increase or decrease on a specific future date without any obligation to buy the asset in question. However, a buyer in options is charged an amount known as a premium by the sellers for a claim.
If the market prices become unfavorable for options holders, they have the option to expire worthless and not exercise the right. It ensures that potential losses are not higher than the premium amount. Alternatively, if the market prices move in the track that makes the right more valuable, they can exercise the trading.
Example of Options Trading
After understanding the basics of options, here we have described its example. In the example, we have used the company Costco as a fiction.
Suppose on 1st March, the stock price of Costco company is $75, and the set premium is $10 for a June 80 call. It means that the expiration is the 3rd Friday of June, and the strike price is $80. The total price of the contract is $10 x 100 = $1000.
Keep in mind that a stock option contract is the option to buy 100 shares. That is why you must multiply the contract by 1000 to get the total price. The strike price is $80, which means the stock price must rise above $80 before the call option is worth anything. Moreover, the contract is $10 per share the break-even price would be $90.
When the stock price is $75, it is less than the $80 strike price, so the option is worthless. But don’t forget that you have paid a $10 premium for the option, so you are down by this amount at this time.
Three weeks later the stock price is $95. The option contract has increased along with the stock price and now is worth $20 x 100 = $2000. Subtract what you paid for the contract, and your profit is ($20 – $10) x 100 = $1000. At this point, you can sell your option, which is called closing position, and take your profits.
By the expiration date, the price decreased and is now $68 as the price is less than our strike price, which is $75, and there is no time left; the option contract is worthless. Right now, we are down to the original investment of $10.
Types of Options
Options trading is basically a derivative security as its price links to the price of something else. This trading has two types, including;
- Call Option: In this type of trading, the buyer of the contract purchases the right to buy an underlying security at a designated price within a specific period. The price a buyer pays is known as the strike price, and the end date for exercising a call option is known as the expiration date.
- Put Option: This trading type is opposite to the call option. So, instead of having the right to buy an underlying security asset, the buyer of the contract purchases the right to sell it at a fixed strike price in the future. Moreover, the put option also has an expiration date.
Common Strategies in Options Trading You Should Know
There are many strategies in options that limit and maximize the return. Here we have shared some common strategies of options that every investor must know.
1. Long Put
A put option allows the holder the right to sell the underlying at a set price. This strategy is preferred for a trader who is bearish on stocks like indexes or ETFs but wants to take on less risk than with a short-selling strategy. Furthermore, this strategy fits people who want to use leverage to take the benefit of dropping values.
2. Short Put
It is the reverse strategy in options trading of long put, but in short put, a trader sells a put and expects the stock price to be above the strike price when the expiration date occurs. In exchange for selling a put, the trader gets a cash premium, which is the most a short put can earn. If the stock closes below the strike price at option expiration, the trader must buy it at the strike price rate.
3. Long Call
In this strategy, a trader buys a call and expects that the expiration will exceed the stock price. If the stock soars, the benefit of this trade is uncapped, and traders can get many times their initial investment. While the price falls, the losses are limited to the premium paid for the option and no more.
However, this strategy is preferable for those traders who are confident about a particular stock, ETF, or index and want to limit the risk. Additionally, traders want to use leverage to take advantage of rising prices.
4. Short Call
In a short call, option traders sell a call but also buy the stock underlying the option 100 shares for every call sold. Keeping the short-call stock turns a potentially risky trade into a safe trade that can produce income. Traders expect the stock price to be below the strike price at the expiration date.
But if the stock finishes above the strike price, the owner must sell the stock to the call buyer at the strike price. However, this strategy is preferred for traders who expect no change in the underlying price, collect the full option premium, and want to limit the upside potential in exchange for downside protection.
5. Long Straddle
In a long straddle strategy, a trader buys both a call and put option with the same strike price and expiration date. The direction of the market movement after it has been applied has no bearing on profit and loss. Traders get profits from weighty price movements in both directions.
6. Short Straddle
Unlike long straddle, short straddle strategy allows the traders to sell both a call and put option with the same strike and expiration date. It is applied during the times when the market is less volatile. Traders will get profit from minimal price fluctuations.
7. Married Put or Protective Put
In this options trading strategy, a trader buys an asset and buys an (ATM) put option at the same time for an equivalent number of shares. The holder of a put option has the right to sell stock price, and each contract is worth 100 shares. Traders opt for this strategy to protect the downside risk when holding a stock.
