Options Trading
What Are Options? Options are derivative contracts that give the buyer (also called the option holder) the right—but not the obligation—to buy or sell an underlying asset at a specific price by a certain date. In exchange for this right, the buyer pays a premium to the seller (or writer) of the option. If the market moves unfavorably, the buyer can choose not to exercise the option, limiting their loss to just the premium paid. But if the market moves in their favor, they can exercise the option to take advantage of the price movement and potentially profit.
Options Trading
Options are generally divided into “call” and “put” contracts. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price. Let’s take a look at some basic strategies that a beginner investor can use with calls or puts to limit their risk. The first two involve using options to place a direction bet with a limited downside if the bet goes wrong. The others involve hedging strategies laid on top of existing positions.
Why Trade Options?
There are some advantages to trading options for those looking to make a directional bet in the market. If you think the price of an asset will rise, you can buy a call option using less capital than the asset itself. At the same time, if the price instead falls, your losses are limited to the premium paid for the options and no more. This could be a preferred strategy for traders who: Are “bullish” or confident about a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk Want to utilize leverage to take advantage of rising prices Options are essentially leveraged instruments in that they allow traders to amplify the potential upside benefit by using smaller amounts than would otherwise be required if trading the underlying asset itself. So, instead of laying out $10,000 to buy 100 shares of a $100 stock, you could hypothetically spend, say, $2,000 on a call contract with a strike price 10% higher than the current market price.
Covered Calls
Unlike the long call or long put, a covered call is a strategy that is overlaid onto an existing long position in the underlying asset. It is essentially an upside call that is sold in an amount that would cover that existing position size. In this way, the covered call writer collects the option premium as income, but also limits the upside potential of the underlying position. This is a preferred position for traders who: * Expect no change or a slight increase in the underlying’s price, collecting the full option premium * Are willing to limit upside potential in exchange for some downside protection A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option’s premium is collected, thus lowering the cost basis on the shares and providing some downside protection. In return, by selling the option, the trader is agreeing to sell shares of the underlying at the option’s strike price, thereby capping the trader’s upside potential.
