Estimated reading time: 5 mins
An option refers to a contract that gives buyers the right, not the obligation, to purchase or sell an underlying asset at a given price. Just like stocks or bonds, options are security and constitute binding contracts with strictly defined terms as well as properties.
Understanding the Different Types of Options
There are only two types of options; call options and put options. One option contract controls up to 100 shares of stock. However, you can purchase or sell as many contracts as you’d like.
By purchasing a call option, you’re purchasing the right to buy 100 stock shares from the seller of that particular option at a predetermined price, known as the strike price. But you’ll have to exercise your call within a specified time or it expires. To buy a call option, you need to pay the seller a given premium. When holding a call option, your main hope is that the stock’s market price increases soon. In case the stock price increases to an extent that it surpasses the strike price, you can comfortably exercise your call and purchase that stock from the seller of the call option at the strike price. Then you can decide to hold the shares or sell them for a profit. Nonetheless, if the stock price goes down, you’ll have to let your call option expire and your loss will be limited to the premium cost.
When you purchase a put option, you’re simply purchasing the right to force the trader who sells you the put to buy 100 shares of a given stock from you at a particular strike price. By holding put options, you’re hoping that the stock price will drop below the strike price. And when it does, the seller of that put will have to purchase stock shares from you at the set strike rate, which will be greater than the market price. Since you can force the option seller to buy your stock shares at a price higher than the market value, put options serve as an insurance policy against your stock shares losing too much value. On the other hand, an increase in the market price means that your shares have increased in value. So, you can simply allow the option to expire since all you’ll lose is the cost of premium you incurred when purchasing the put.
Most traders purchase put options since they believe a commodity market will move lower, allowing them to make huge profits. But the good thing is that you can always exit the option before the contract expires-during market hours. All put options have a limited life. Typically, they’re defined by specific expiration date.
Buying options give you a hedge against losses. However, it’s important to note that not all options strategies will be convenient for all investors. This is because different strategies come with different complexities and risks. You can always purchase a put option in stock commodities or future markets if you expect the underlying future cost to move lower.
Purchasing a put option gives you as a buyer of the right to sell an underlying contract at the strike price as long as the contract hasn’t expired. It rarely happens and there isn’t much benefit that comes with doing this, so trade carefully when buying a put option.
You should always start by defining your objectives and then identifying the best option to purchase. Some of the things to consider when making your purchase include:
- Length of time you intend to say on the trade
- The amount of money you’re willing to pay for a put option
- Expected length of a move from the market
New commodities, as well as future markets, have an extensive range of options in various expiration months plus different strike prices which allow you to choose an option that perfectly meets your objectives.
Length of Time You Intend To Remain On the Trade
This will assist you to determine the amount of time you’ll need to invest in a put option. If you’re expecting a stock to complete its move in less than 14 days, you’ll want to purchase a commodity with over two weeks left on it. You don’t want to purchase an option with 6 to 9 months remaining if you’re planning to stay in the trade for a few weeks since the options will be quite costlier and you’ll lose some leverage.
Remember, the time premium of options tends to decay more rapidly during the last 30 days. Thus, you could be right on a given trade, but the option loses a significant amount of time value, and you eventually end up with a loss.
Purchasing Put Options
Put buying is another simple way of trading put options. If the options trader is bearish on a specific security, they can buy put options to benefit from a decrease in stock price. The stock price should fall significantly below the put option’s strike price before the expiration date for this business strategy to be profitable.
Put spreads are an options strategy where an equal number of option contracts are purchased and sold simultaneously under the same underlying security with varied strike prices as well as expiration dates. Typically, put spreads minimize the options trader’s losses at the expense of capping their potential profit.
Selling Put Options
Rather than buying put options, you can as well opt to sell them for a profit. Those who sell put options do son in the hope that they’ll expire worthless, allowing them to pocket some premiums.
Protective Put Options
Investors can also purchase put options when they want to protect an already existing long stock position. And these put options are commonly referred to as protective puts. With the help of index puts, you can effectively protect your entire portfolio of stocks.
Options trading provides an amazing way for traders to sell and purchase stocks at a lower cost. They offer increased flexibility as well as an endless list of opportunities for investors to reap huge profits. Once you master the above tips and tricks, you can always trade like a pro!