Options Trading Guide
Understanding the components of options trading clearly outlines how much advantage a trader has.
Without a doubt, people who have sufficient knowledge of a certain trade have better chances of profiting from it. In the same way, a trader who is knowledgeable in options trading has better control of his profits.
In this article, basic concepts of Options Trading will be presented. Let it be noted that the information covered here are intended for neophytes in options trading.
What is Options Trading?
Option trading is a category of trading stocks, bonds or any type of assets that acts more like a contract. Which allows for liberty to buy or sell the asset but does not necessarily oblige the holder to exercise his powers within a certain period of time. In layman term, it simply means “buying” the right to buy or to sell an asset within a specified duration. It should be noted that buying the option is very different from buying the stock itself.
What is an Option Contract?
An option contract is an agreement wherein the owner has the right to buy or sell a security or an asset at a particular price on a fixed date in the future. It is called an option because the owner of the contract is not committed to carry out the obligation of the contract if he or she feels that it is disadvantageous.
What are the types of options?
There are two types of options: the calls and the puts. Both of them work in exactly opposite principles.
The calls are options that provide the right for a holder to buy a certain asset at a specific price, during a specific period. This investment will be profitable only if the stock would increase during the period of the option. Calls are also oftentimes considered long positions.
In simple terms, call options give the owner the right to buy the underlying asset in the contract. Again, it is not an obligation.
John and Tom agreed on a call options contract wherein John will buy from Tom, 100 shares (equivalent to one option) of Company A at $20 (strike price) what will expire on the third Friday of April. The current price of the share is $20.
At the expiry date (also called maturity date), the share price of Company A remains at $25. John can then exercise his right to buy the share for $20 and thus, yielding $5. Meanwhile, if the share price goes down to $22, John can still earn $2 by simply exercising his rights as stated in the contract. In whichever way, any amount higher than the strike price at the end of the contract will become the profit of the owner. But before it can happen, the owner who decides to pursue his right has to have his money ready to pay for the amount.
However, if the share price goes down below $20, say $18, on the maturity date, it will be too expensive for John so he can just ignore the contract since he is not obliged to carry it out. He will only lose the amount he paid for the contract called the Option Premium. Tom, on the other hand will keep the asset and the premium, which in a sense, is his profit.
The puts, on the other hand, are options that provide a holder to sell the asset at a certain price, within a specific period. This will yield profit for the holder if the stock price will depreciate during the period. Conversely, puts are often seen as short positions.
In other words:
In put options, the buyer has the right to sell an asset to the writer (the seller). Just like the call asset, it is bounded by a contract which states that the underlying asset will be sold at a particular price and a particular date. But the similarity ends there. In put options, the writer has to buy the underlying asset at the strike price if the buyer exercises this option.
Let us continue with John and Tom. John bought call options from Tom. But he could also buy put options from Tom. If John buys put options, it means that he buys the right to sell Company As shares at $20 on April 1. If the price of shares goes down below $20 on the expiry date, John can exercise his right and can still sell it at $20, thus making a profit.
Buying put option allows investors to earn when price of shares drops at the end of the contract.
Profit potentials are unlimited for the buyers of put options, especially if the market begins to sell off. On the other hand, risks are limited if the market goes against them.
In reality, trading of options or transactions does not happen between two persons. Buying or selling can happen without knowing the identity of the other party.
Options are only sold in 100 (or more) share lots. So if the share price is $20, you will have to pay $2,000 for each option contract plus the Option Premium.
What are the styles of option trading?
There are two: The American Style Options and The European Style options.
The difference between the two lies on the date when the option can be exercised.
In European Style options can only be exercised after the expiration date.
American Style option, on the other hand, provides more leeway as it allows the option to be exercised from the day of purchase until the day it expires.
Most stock traders hold the common misconception that the style of options depends largely on the geographical location where the trade was made. Wrong. Actually, the names American and European styles are just terminologies to separate one style from the other. It does not necessarily mean that when one trades in Europe, the trading style adopted is automatically a European Style or vice versa.
Who are the Buyers and Sellers in Option Trading?
These two types of options then lead to four different types of traders namely, the buyers and sellers of the calls, and the buyers and the sellers of the puts.
But, buyers and sellers of options are further distinguished by their general names: buyers are called holders and sellers are called writers.
Buying and selling of options comprise a very complicated scheme of trade. For the holders of calls a puts, an options contract does not oblige them to participate in the trade through either buying or selling. They have, at their disposal, their rights to either maintain an asset or to dispose it.
However, for writers of calls and puts, the contract necessitates that they either buy or sell an asset.
Option trading is by nature, a speculative type of trade. In trading-speak, it suggests that this kind of trading best suits those who seek risks and enjoy taking them.
Enjoy Reading & Happy Investing!!!