Options trading may look remarkable and easy at first sight, but it is not that easy to understand if you have command of very few concepts. Trader portfolios are generally made with various asset classes. These may include bonds, ETFs, mutual funds, and even stocks. Another asset class is the options, and if used correctly, they provide many advantages that trading ETFs and stocks alone cannot.
Options and Derivatives
Options belong to the broader set of securities which are known as derivatives. The price of a derivative is derived from and is dependent on the price of something else. Options are regarded as the derivatives of financial assets or securities, and their value lies in the cost of some other assets. Some of the examples of derivatives include puts, calls, futures swaps, mortgage-backed securities, and forwards.
Call and Put options in detail
As mentioned above, options come under the category of derivative security. If one purchases an options contract, it allows a trader the right (but not the necessary) to either sell or buy an underlying security at a given or set price before or on a particular date. For example, a put option provides an owner with the right to sell shares of stock, whereas; a call option grants the purchaser right to purchase a stock. In addition, you can relate a call option with the down payment for future investment.
Example of the Call option
A homeowner notices a new development. That person may wish for the right to buy a house in the future but will only want to apply that right once the various other constructional developments are built around that specific area.
The potential home purchase will only benefit from the option of purchasing or not. For example, consider a case where he can buy a call option from the respective contractor to buy the house at, say, $500,000 at any point in the following three years. Well, he can because it is a non-refundable deposit.
Typically, the contractor wouldn’t allow such an option for free. Instead, the homeowner needs to deposit a down payment to lock in the right of the house. Concerning options, this price reflects the price of the option contract. In this case, the deposit might be $20,000 that the purchaser pays the contractor.
Two years have passed, and now the constructions are built, and zoning has been confirmed. The house purchaser applies the option and purchases the house for $400,000 because the contract was purchased. The value of the home in the market may have doubled to 1000,000. But just because of the down payment locked in and pre-determined price, the purchaser gives $500,000.
Now, if the zoning approval doesn’t come until four years, it is one year past the expiration date of this option. So now, the buyer must pay the market price because of the expiry of the contract. The contractor keeps the original amount of $20,000 collected in either case.
Example of the Put option
Assume a put option as an insurance policy. You might be aware of the buying homeowner’s insurance. Suppose the homeowner purchases a policy to guard his house against damage. He spends an amount known as the premium for some time, let’s assume a year. This insurance policy provides the holder protection if the house is damaged and has a face value.
What if the asset was an index investment or stock instead of a house?
Similarly, if a trader wishes insurance on their S&P 500 index, they can buy put options. For example, suppose a trader fears that a market will be bearish in the coming time and is unwilling to lose more than ten percent of his long position in the S&P index. If the index (S&P 500) is currently trading at $2500, they will buy a put option allowing the right to sell the respective index at $2250 (at any point in the following two years).
Purchasing, selling Puts/Calls
There are four options one can pursue with the options:
- Buy calls
- Sell calls
- Buy puts
- Sell puts
Purchasing stock provides a trader with a long position. Purchasing call option offers the trader a potential extended place in the underlying share. Short-selling a stock offer trader a short position. Selling uncovered or naked call provides a short position in the underlying stock.
Purchasing a put option provides the trader with a potential short position in the underlying share. Selling an uncovered put option provides a potential long position in the underlying stock. These four scenarios are crucial and should be kept straight in mind.
The trader who purchases options are known as holders, and those who sell options are known as writers of options. Here is the distinction between writer and holder.
- Put holders (purchaser) and call holders are not confined to selling or purchasing. They have the choice to manage their rights. It helps limit the risk of purchasers of options to only the premium amount.
- Put writers (sellers) and Call writers, on the other hand, are confined to sell or purchase if the option expires. It reflects that a seller may be required to make the promise to sell and buy. It also means that the option sellers have coverage to more and, in some situations, unlimited risks. Finally, it directly implies that the writers can lose much more than the cost of the options premium.
Bottom line
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