Options are a type of financial derivative derived from the underlying investment or stock. The purchaser receives the right to purchase or sell the underlying stock at a predetermined price but is not obligated.
Leveraged options have a higher risk and limitless returns.
Comparing Stocks and Options
Options are distinct from equities in the Stock Exchange market because of their unique features. Before trading options, investors should familiarize themselves with the language and concepts used.
When you buy stock, you become a shareholder of a firm, while when you purchase an option, you can sell the stock at an agreed price by a set date.
Knowledgeable investors prefer trading in options compared to stocks because options give a higher return. The risk is also lower than trading in shares, and the capital outlay is not as massive.
It is a lot like betting on the fastest car at a racetrack when you trade options. In a poker game, each player wagers against the entire group. The facilitator takes a modest share to cover the costs of the amenities. As a result, trading options is a zero-sum game like betting on the fastest car in a race. There is always a trade-off between the option buyer and the option seller.
It’s crucial to understand that every option transaction has two sides: a buyer and a seller. To put it another way, in every option bought, somebody is selling it.
The Two Options Available
Calls and puts are the two options available. When Saxo bank purchases a call option for you, you have the right, but not the duty, to purchase a stock at an agreed date (strike price) any time preceding option expiration.
When you purchase a put option, you have are allowed but not obligated to sell the underlying security at the strike price before the end date.
When investors sell options, they immediately create a new tradeable financial asset in a process referred to as Option Writing. Option writing is a crucial source of options because it is not coming from the company or the Belgium Exchange.
An investor who writes a call is required to trade off the underlying stock at the strike price, any time earlier than the expiration date. Similarly, a dealer who writes a put option has to buy stocks at the strike price at any time preceding the contract end date.
A put option or a call option strike price is the price whereon a trader can exercise. In other words, a strike price is also the exercise price.
There are two primary styles American Style Option and that of the Europeans. There is a significant differentiating characteristic between the two.
A European index option ceases trading one day earlier, while the American style option is valid before the end date and on the expiration date.
Where Is the Money?
When an underlying asset, for example, a stock, appreciates above the strike price before the end date, the call option buyer profits. Put option buyers make profits whenever the prices depreciate beyond the strike price any time before the due date.
Profitability, therefore, depends on the cost variation between the stock price and the option strike price before the due date or the option position closure.
It is possible to make money if the stock remains less than its strike price. If the price goes higher than the strike price after the trader has written a put option, they profit. Profitability is restricted to the money an option writer collects (the option buyer’s cost) when writing an option. Option sellers are also known as option writers.
Options are complex to understand and need extensive learning to be able to make profits. Regular options attract a low risk, but leveraged returns are risky.