Options are used for many different purposes and can be applied to stocks, futures, currencies and more. Options trading is one of the most complicated forms of investing there is.
There are many different types of options that investors use which can make it difficult for beginners to know where to start. That’s why we created this guide – so you can learn about what options are available and how you can use them in your portfolio.
What is an Option Contract?
An option contract is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a pre-determined price on or before a specified date. It is a type of derivative security.
Option contracts are used to hedge against risk, speculate on asset prices, and generate income. The option holder pays a premium for this contract. The terms of an option are agreed upon by both parties and may vary from one instrument to another.
Option Pricing and the Value of the Option on Expiration Day
Options can be a great investment if you know how to use them. There are two main types of options: Call options and Put options.
Call Options give the holder the right to buy a given number of shares at a certain price up until the expiration date. Put Options give the holder the right to sell a given number of shares at a certain price up until the expiration date.
There are many things that you need to keep in mind when buying an option. You can use the following guidelines to help you make a decision.
- The more time you have, the more time value will be built up on the option.
- The greater the volatility of the stock, the higher the premium will be for an out of money call or put.
- If you buy a call, then it is always better to buy it when there is a high amount of time value in it.
Buying Calls & Puts
Buying calls and puts is a strategy that can be used by investors who are confident in the direction of a company’s share price. Buying calls enables an investor to purchase a call option on a stock in anticipation of the share price increasing over the term of the option.
Buying puts is similar, but it allows an investor to purchase a put option in anticipation of the share price decreasing. The returns from buying calls and puts are identical if the shares increase or decrease by exactly one dollar during their respective life.
Example: Stock XYZ is trading for $20 per share. You can buy a call option, which limits your loss to $2 and lets you profit if the price jumps up; the benefit of this option is that that it expires in 8 months and costs only $200.
Selling Covered Calls & Puts
Selling a call or a put is the most conservative way to trade options. A covered call is when an investor sells (or “writes”) a call option and at the same time buys (or “holds”) 100 shares of the underlying stock. The investor can execute this strategy when they feel that the price of the underlying stock will not rise above the strike price before expiration.
The holder of a put option, on the other hand, has effectively shorted 100 shares of the underlying security by selling it as an option, so they profit if it goes down in value.
Example: Stock XYZ is at $20 per share, and a call with a strike price of $20 with an expiration in four months is at $1. A premium of $100 is paid by the contract. A trader buys 100 shares of stock for $2,000 and sells one call to receive $100.
The Bid, Ask and Spread
The bid-ask spread is one of the most important factors in determining how much it costs to trade options. The wider the bid-ask spread, the more expensive it will be for investors to trade options. The narrower the bid-ask spread, the cheaper it will be for investors to trade options. Here are some important things to consider:
- Option bid is the price that the option buyer pays for the option contract.
- Option ask is the price that the option seller receives for selling an option contract.
- Option spread is the difference between an option bid and an option ask. This helps to measure the liquidity of an option contract.
Additionally, bid and ask prices are set by market makers who are quoting prices that they are willing to buy or sell at any given moment. This means that when a market maker has a large amount of shares available at their quoted price, they will widen their quoted offer (the ask).
Conclusion – Tools You Need To Get Started
Option trading platforms are the best way to get started in the world of options trading. They provide a range of tools and resources that will help you to become a successful trader. Many brokers now offer commission-free trading such as Webull and Robinhood that allow you to get quickly setup and running.