For investors who want to diversify their portfolio holdings and generate enhanced income, trading options is a viable way to do that.
Below you will find three simple lessons about how to trade options and how to try to earn some serious profit. However, options trading comes with risks and investors should be prepared to withstand losses from this high-risk, high-reward strategy.
1: What is an Option?
Options are securities, just like stocks and bonds, that are traded between separate parties with the goal of generating a profit. But beware of potential losses.
An option is a contract that is sold by an individual, who is known as the option writer. The option writer receives a premium for selling the security to another investor who is called the buyer, or the option holder. The option buyer has the right, but not the obligation, to buy or sell an underlying security, which could be a stock, bond, index, interest rate, currency or commodity, at a specified price within a certain time period.
The specified price is known as the strike price. The specified time period ends at the close of the expiration date. If the option holder chooses to buy or sell the underlying security before the expiration date, then he is exercising the option. The alternative would be not to exercise his right and allow the option to expire worthless.
Options can be intriguing to investors who think they have a good idea about the future market value of a particular security. Two basic but different options are calls and puts. The following is a description of each.
2: Call Options
Call options give the buyer the right to purchase the underlying security at the strike price. Call options generally are bought when the buyer expects the value of the stock, also known as the underlying security, to rise. In contrast, call options can be sold when the writer expects the value of the stock to go down or stay relatively constant.
From the perspective of the option buyer, a stock price at or above the strike price is known to be “in the money.” This means that the option holder can buy shares of the stock at the strike price, then sell the shares at the market price (to the option writer) to generate a profit.
From the option writer’s (seller) perspective, if the stock price is below the strike price, then the option is known to be “out of the money.” When the option is out of the money at expiration, then the option becomes worthless. This is good for the option writer because he profits by keeping the premium paid by the buyer. (Every buyer of an option must pay a premium to the seller of the option). When the option becomes worthless, the option writer does not have to pay the option holder anything and keeps the premium he received.
3: Put options
An alternative to call options are put options, which give the buyer the right to sell the underlying security at the strike price. Put options generally are bought when the purchaser expects the value of the stock, also known as the underlying security, to fall, and sold when the seller thinks the value of the stock is going rise or stay relatively constant.
From the option holder’s perspective, if the stock price is below the strike price, then the option is known to be “in the money.” In this case, the option holder can profit by buying the stock at the market value, but then selling it for a higher price at the strike value to the option writer (the option writer is obligated to buy the stock if the holder chooses to exercise his right and sell the stock within the expiration date; remember, options are contracts).
The option holder is going to profit if the premium he paid is less than the amount gained by selling the stock above the market value at the strike price. From the option writer’s perspective, if the stock price is above the strike price, then the option is “out of the money.” This means that the option will expire worthless. Therefore, the option writer will keep the premium paid to him by the option holder. The writer will not have to pay the holder anything if the option expires.
In summary, the three basics of option trading are: what are options, what are calls, and what are puts. Now you know three basics to consider when trading options. Plus, you understand how certain scenarios in the market can generate big profits or losses depending on the strategy of a call or a put option.