A traded option is a contract that confers the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specific date. Traded options are divided into two categories: calls and puts.
Call options give the holder the entitlement to buy an underlying asset at a specified price on or before a specific date. Put options give the holder the entitlement to sell an underlying asset at a specified price on or before a specific date.
The vast majority of traded options are categorised as either European-style or American-style. Traders can only exercise European-style options on the expiration date, while they can exercise American-style options at any time up to and including the expiration date.
Traders can use options to hedge an existing position
Hedging a position refers to taking an offsetting position in related security to protect oneself from losses if the original investment decreases in value. For example, let’s say you own 100 shares of ABC stock, which currently trades at £10 per share. You are concerned that the stock might decrease in value over the next month, so you buy one ABC put option with a strike price of £9 and an expiration date of one month from now.
If the stock declines in value, your put option will increase in value. The put option will give you the right to sell your shares at £9 each, even if the market price has fallen below that level. If you exercise your option, you can sell your shares and realise a profit even if the stock price has declined.
If the stock price doesn’t decline, your option will expire worthlessly, and you will only be out of the cost of the premium.
Traders can use options to wager on the direction of a security’s price
When you buy or sell a call or put option, you are speculating whether the underlying security’s price will rise or fall. If you believe the security’s price will rise, you will buy a call option. If you believe the security’s price will fall, you will buy a put option.
The amount of profit or loss from speculation depends on how much the underlying security price changes, the strike price of the option, and the expiration date.
You can use options to generate income
Traders can use several strategies to generate income, such as writing covered calls or selling puts.
A covered call involves writing (selling) a call option on the security you own. If the security price does not rise above the strike price of the call option by expiration, you will keep the premium and write another covered call. If the security price rises above the strike price, you may be assigned and have to sell your shares at the strike price.
Selling a put involves writing (selling) a put option on a stock you do not own. If the stock’s price remains above the put’s strike price by expiration, you will keep the premium and can sell another put. If the stock’s price falls below the put’s strike price by expiration, you may be assigned and have to buy shares at the strike price.
Options are a zero-sum game
When one trader buys an option, another trader sells it. Therefore, for every buyer, there must be a seller. Therefore, options are a zero-sum game.
The profit or loss from buying or selling an option is equal to the difference between the option’s premium and the option’s strike price, multiplied by the number of contracts.
For example, let’s say you buy one ABC call option with a strike price of £10 and a premium of £1. The option expires in one month, and ABC is currently trading at £9.
If the stock price does not rise above £10 by expiration, the option will expire worthlessly, and you will lose the £1 premium.
If the stock price rises to £11 by expiration, you can exercise your option and buy shares at £10 each. You can sell those shares on the open market for £11 each, making a profit of £1 per share. Click here to start with online options trading today.