Options are derivative contracts that provide you the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price in the future.
If utilized properly, options are excellent for generating profit, managing risks, and predicting the future direction of the overall stock market or individual assets such as stocks or bonds.
While they can appear complicated and hard to understand in the beginning, learning about them can be a less difficult endeavor once you get familiar with some of their fundamental concepts.
Options Explained
Options are a type of derivative contract that allows, but does not obligate, the holders to buy or sell a share of stock at a set price by a defined date.
In an options contract, there are two people involved. The first person is responsible for the option’s creation, which traders describe as the contract’s writer. The second person is the one who will be buying the option, i.e., the would-be option holder.
The writer of the contract is required to buy or sell the underlying stock if the need calls for it. The option holder has the choice to carry out the contract at a later date. But they are not required to follow through or finish the trade.
2 Types of Options Contract
Options are classified into two types: Call options and put options.
Call options or calls grant buyers of options the right to purchase stock from the person who created the option for a limited amount of time. On the other hand, put options or puts allow buyers to sell stock to the writer of the options contract at an agreed-upon price in the future.
Note that the buyers of the call or put options are not obligated to buy/sell stock from option creators.
3 Elements of Options
Premium
Options contracts are sold for a price known as premium. Premiums vary over time. They depend on certain factors, including the time until the contract expires, the primary asset’s volatility, and whether there is intrinsic value.
Strike Price
The strike price or exercise price represents the price at which the option holder can execute the option to buy or sell the underlying asset.
Expiration Date
Options contracts also have an expiration date or deadline, stating the last time the contract can be carried out. Usually, options contracts have a 30-, 60-, or 90-day expiration. But some have an exchange deadline of up to one year.
A longer expiration date typically means a higher premium as a more extended deadline presents a stronger prospect of the primary share price taking the right course to enable the holder of the options to make money.
Options as Hedge Against Risks
One of the reasons that make investors hold options is their ability to hedge risks. Investors who have stock positions can buy puts to manage risks and minimize their losses.
Put options, for instance, allow buyers to sell the underlying shares at a certain strike price on or before the deadline. As a result, their value increases when the primary stock price falls since their holder can now sell the dropping stock at a markup.
Turning a Profit with Options
The strike price is vital to learning the way options generate profit. Whether the underlying asset’s price surpasses or ends below the strike price, the people involved in the contract are either in the money (ITM) for an excellent trade or out of the money (OTF) for a poor trade.
In the Money (ITM)
ITM means that the option has intrinsic value and that call options are profitable for holders when the primary stock price climbs past the strike price. On the other hand, put options become profitable for buyers when the stock price is lower than the strike price.
Out of the Money (OTM)
OTM indicates that the option lacks intrinsic value but has extrinsic value. During OTM situations, calls offer no profit opportunity for buyers when the underlying stock’s price is below the options’ strike price.
Conversely, if the stock price rises above the strike price, puts are the ones that offer no profit opportunity for the option holders.
At the Money (ATM)
Another situation that can occur with trading options is called at the money (ATM). ATM happens when the current market price of the primary stock is the same as the option’s strike price.
Considering all that, here’s how you can turn a profit with options:
When a call option is ITM, the buyer of the contract can execute the option and buy the underlying stock from the writer at a price less than what it costs on the market. As a result, the buyer paid a small premium to purchase stock at a discount.
When the put option is ITM, the option holder can execute options, which then requires the writer to buy the stock at a price higher than the shares’ current price in the market. The buyer paid a reasonable fee to sell the stock for a price higher than what it is currently worth on the market.
For the option writer, profit is made when the contract is OTM for the buyer at expiration.
For example, the person who purchased the contract is allowed but not obligated to complete the deal. And if a call or put is OTM, they don’t execute the option. That leaves the writer with the premium, i.e., his money on the trade.
Losing Money with Options
Whether it’s puts or calls, options contracts are of no value once they expire, and the holder loses the premium he paid for the option.
With put options, buyers cannot sell stock at a price higher than the market price to the option writer. With call options, buyers can’t purchase the shares at a lower price.
Options are frequently used as leverage. They allow investors to invest in more stock with less money and further increase their potential returns. That said, using options as a form of leverage also raises the risks of investors losing more than they can afford.
Option holders only lose the premium, but the writers are at risk of losing so much.
With calls, the buyer is ITM when the stock’s price is above the strike price. However, there is no limit to how high the stock prices can go. That means there is no limit to how much the option writer can lose. With puts, the stock can only be at zero.
