101, What Are ?

An option is a contract that gives the buyer the right, not the obligation, to buy or sell an underlying asset at a specific on or before a certain date. An option is a security. It is also a binding contract with strictly defined terms and properties.

The notion behind an option is present in many everyday events, but for this discussion the underlying asset of an option is a stock or an index.

The 2 types of options are Puts  and Calls

A Call gives the holder the right to buy an asset at a certain price within a specific time frame. Calls are similar to having a Long position on a stock. Buyers of Calls hope that the stock will increase substantially before the option expires.

A Put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are similar to having a Short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

There are 4 types of participants in options markets depending on the position they take:

1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts

People who buy options are called holders and those who sell options are called writers. Buyers are said to have Long positions, and sellers are said to have Short positions.

There is an important difference between buyers and sellers

Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.

Call writers and put writers (sellers) are obligated to buy or sell, meaning that a seller may be required to make good on a promise to buy or sell.

Let’s look at options from of the buyer perspective. Selling options is more complicated and can be even riskier, so you must understand that there are 2 sides of an options contract.

In order to trade Options, you must know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the Strike Price. This is the price a stock price must go above (for Calls) or go below (for Puts) before a position can be exercised for a profit, and this must happen before the expiration date.

An Option that is traded on a national Options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These securities have fixed strike prices and expiration dates. Each listed Option represents 100 shares of company stock aka the contract.

For Call options, the option is said to be in-the-money if the share price is above the Strike Price. A Put option is in-the-money when the share price is below the Strike Price. The amount by which an option is in-the-money is referred to as Intrinsic Value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility.

Because of all these factors, determining the premium of an option is complicated and beyond the scope of this article.

There are 2 Key reasons why an investor would use options: speculate and hedge.

Speculation means betting on the movement of a security. The advantage of the option is that the holder  is limited to making a profit only when the market goes up. Because of the versatility of the options money can be made when the stock goes down or sideways.

Speculation is the arena where the big money is made and lost.

The use of options for this is the reason options can be risky. When you buy an option, you have to be correct in determining not only the direction of the stock’s movement, but also the magnitude and the timing of this movement.

So, to win, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And there are commissions, these factors means the odds are stacked against the speculator.

Aside from versatility, this game is all about leverage. When you are controlling 100 shares of a stock with 1 contract, it does not take much of a price movement to generate substantial profits.

The other function of options is hedging.

Hedging is like and insurance policy. Just as you insure your possessions against loss, options can be used to insure your investments against a downturn.

Hedging strategies can be useful, especially for large institutions. Even the individual participants can benefit from hedging with options.

Example: you wanted to take advantage of technology and their upside, but you also wanted to limit any losses. By using options, you would be able to restrict your Southside while enjoying the full upside in a cost-effective way. There are some good books written on this subject.

There is a 3rd reason for using options.

Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right, but not the obligation to purchase company stock. This contract is between the holder and the company, whereas a normal option is a contract between 2 parties that are unrelated to the company.

Options are not for all investors.

Options are sophisticated trading tools that can be dangerous if you do not educate yourself before using them. This article is a starting point to learning more about options.

It is you money, and your responsibility to learn and manage it properly.

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