Options trading may be overwhelming to beginners. However, it is not difficult to grasp if you are given some key pointers. The portfolios of investors usually contain different classes of assets. They may be mutual funds, ETFs, bonds, and even stocks. Another class of asset is “options.” And when you use them in the right way, you can enjoy the numerous benefits that trading ETFs and stocks alone cannot offer.
Options – What Are They?
Options refer to contracts that offer its bearer rights, not obligations, to either sell or buy some principal assets at a fixed price before or at the expiration of the contract. You can purchase them the same way you buy other classes of assets using a brokerage investment account. You may want to check out Jeff Clark trader stock options to know more about purchasing them.
Options are very powerful because your portfolio can appreciate if you have them. They offer leverage, protection, and additional income. Based on your investor goal, you can find a befitting option storyline.One popular instance is the case of acquiring them in order to have a hedge against the unstable stock market, thereby, limiting the downside losses.
You can also use them as a means of generating recurring income. You can use them for the purpose of speculation like wagering on a stock direction.
Just like bonds and stocks, nothing comes free in options. You must expect some risks and you have to know them before trading. This explains why you will get a disclaimer like the one below when trading with your broker.
Disclaimer: Options involve some level of risk and it may not be suitable for all. Trading could be speculative, and you stand the risk of losing.
Is Options a Derivative Trading?
Options are categorized as derivatives; a larger class of securities. Derivatives include forward contracts, futures contracts, puts, calls, mortgage-based securities, and swaps. And options, just like derivatives, can be used for different investments including commodities, currencies, and equities.
The price of a derivative is derived from or depends on the price of another entity. Hence, options are derived from their financial securities; their value is dependent on the prices of other assets.
You may want to read more about derivatives trading: https://medium.com/interdax/what-are-derivatives-and-who-should-be-trading-them-1887576d46c
Put and Call Options
We have already established that options are a form of derivative. This is due to the fact that its price is linked to that of another item. So, buying it gives you a right to sell or buy a basic asset before or on a particular date.
The call option offers its holder a right to purchase stock while the put option offers a right to sell. You can imagine the call option as some kind of down-payment for future purchases.
What Can You Do with Puts and Calls?
There are 4 things you can do with puts and calls:
- Buy puts
- Sell puts
- Buy calls
- Sell calls
Purchasing a put offers you a possible short position in its underlying stock. When you sell an unmarried or naked put, you get a possible long position in its underlying stock.
Stock buying grants you ownership of the security (long position). So, when you purchase a call, it gives you possible ownership of its underlying stock. When you short sell a stock, you get a short position. When you sell an uncovered or naked call, you get a possible short position in its underlying stock.
It is important to remember the 4 scenarios we have established above.
A long position is a term that describes what you purchase when you buy a derivative or security with the hope that it will appreciate in value. The opposite of this is a short position or short. This is created when you sell a security with an intention of buying it back or purchasing it at a low price.
An investor could short sell a security when they believe that its price may decline in the future. A naked short refers to a trader selling security when they do not even possess it. A covered short refers to when an investor borrows shares from a loan department in the stock market; in return, they pay a borrowing rate within the period of the short position.
When you buy options, you are a holder but when you sell them, you are a writer. You can find more information about that here.
Differences Between Writers and Holders
Here are the important differences between writers and holders:
- Put writers and call writers (sellers) have the obligation to sell or buy if the contract expires. This implies that the seller may need to fulfill their promise of selling or buying. It also means that the seller is exposed to more risks and they can make a loss that is higher than the premium price.
- Put holders and call holders (buyers) do not have obligations to sell or buy. They can choose to use their rights or not. This helps to limit their risk to the amount they spent on the premium.
Options trading is not a difficult area of investment. You just have to understand the basics because when you trade correctly, doors of opportunities will be opened to you. However, when you do not understand the basic concept, you have a tendency of trading incorrectly.