Options are a kind of derivative contract which gives those who purchase the contract (the owners of options) the ability (but they do not have the duty) to purchase or sell the security at the price they choose at some time in the near future. Option buyers pay an amount referred to as a premium by sellers for this right. If the market is not favorable for those who have options they’ll let the option expire ineffective and will not exercise the right and ensure that any possible losses aren’t more than the amount paid for. However should the market move in a direction that makes this option more valuable, it will make the most of it.
Options are usually separated between “call” or “put” options. When you buy a call option the buyer purchase the right to purchase the asset that is the basis in the near future at the predetermined price, which is known as strike price or exercise price. When a put option is purchased that is purchased by the buyer, the buyer gets the option to sell the asset in the near future at the specified price.
Let’s look at the most basic strategies an investor who is new to investing can employ using puts or calls to minimize their risk. The first two strategies involve making use of options to make an order bet that has a small risk of loss in the event that the bet is not successful. Other strategies involve hedging added over existing positions.
Buy calls (Long Calls)
There are a few advantages of trading options for people seeking to make an investment in a direction market. If you think that the price of an asset is likely to rise it is possible to purchase an option to call it with lesser capital as opposed to the actual asset. In addition when the price decreases, your losses will be only the amount you paid for the options , and not more. This could be a good option for traders who
Are you “bullish” or convinced about a certain share, exchange-traded fund (ETF) or index fund and are looking to minimize the risk.
Are you looking to leverage your money to benefit from the rise in prices
Options are leveraged instruments because they permit traders to increase the potential upside potential by investing in lesser amounts than would be required when trading the actual asset. Therefore, instead of paying out $10,000 to purchase 100 units of 100-cent stock it is possible to invest, for instance $2,000 for an option contract that has the strike price being 10 percent higher than the current market value.
Example
Let’s say a trader wishes to put $5,000 into Apple (AAPL) which is trading at $165 per share. With this sum they could purchase 30 shares at $4,950. Imagine that the price of the stock goes up 10 percent to $181.50 during the subsequent month. In ignoring any brokerage commissions or transaction costs The portfolio of the trader will grow to $5,445 which leaves the trader with an overall return in dollars of $495 or 10% of the amount of capital put into.
Let’s suppose that a call option on the stock with a strike value of $165, which expires one month from now. The price is $5.50 per share or $550 for a contract. Based on the trader’s investment budget, they could purchase nine options for the price of $4,950. Since the option contract is a control over 100 shares and the trader is selling the equivalent of 900 shares. If the price of the stock increases 10 percent to $181.50 at the time of expiration then the option will expire in cash (ITM) and will be valued at $16.50 for each share (for an $181.50 up to $165 strike) that is $14,850 on the 900 shares. It’s a return in dollars of $9,990 which is 200% of capital invested, which is a greater return than trading the asset directly.
Risk/Reward
The potential loss for the trader due to a long call will be limited by price paid. The possibility of profit is unlimited since the amount of money that is paid out will rise as does the underlying asset price until the expiration date, and there’s no theoretical limit on how high it can rise.
Buy Puts (Long Puts)
In the event that a call grants the owner the option to purchase the underlying for the price of a specified amount before that contract is due to expire, then a put provides the holder with the option to purchase the underpinning for an agreed price. This is the preferred method for those who:
Are you bullish on a specific index, stock ETF and/or an index and are looking to take on less risk than you would with an option to short sell
Are you looking to leverage your investments to profit from price declines
Put options operate in the opposite direction to what the call option works in that the put option is growing in value as the value of the asset being traded. While short-selling can allow traders to make money from lower rates, there is a risk involved with the short-selling option is unlimitable since there is theoretically no limit to the extent that prices can go. Put options in the event that the value of the option ends at a higher price than the option’s strike price it will end in a useless manner.
Example
If you believe that prices of the particular stock is likely be down between $60 and $50 or lower due to poor earnings however, you do not want to risk selling the stock short in the event that you’re incorrect. Instead, you could buy the $50 put at the price of $2.00. If the price of the stock doesn’t decline under $50 or in the event that it increases, the biggest amount you’ll lose is $2.00 premium.
If, however, you are right and the stock falls until $45, you will earn $3 ($50 less $45. less the premium of $2).
Risk/Reward
The risk of losing money on the long put is limited to the cost of the option. The maximum gain from the put is limited since the price of the underlying instrument cannot be below zero, however similar to a long-call option, a put option increases the return of the trader.
Covered Calls
In contrast to the long call or long put the covered call is an investment strategy that is layered on an existing position in the asset. It’s basically an upside call offered in a amount which will cover the current size of the position. This way the writer of the covered call takes the option premium as income, however it additionally limits the potential upside of the actual position. This is the preferred option for traders who
There is no need to worry about an increase of a small amount in the cost of the underlying, and you will be able to collect the entire option premium
Willing to reduce the potential for upside in exchange in exchange for some downside protection
The covered-call strategy involves purchasing 100 shares in the asset, and then selling an option to call the shares. When the trader makes the call option, the premium for the option is collected which reduces the cost basis on the shares , and giving some protection against the downside. By selling the option the trader has agreed to offer shares in the underwriting company at the strike price for the option and thus limiting the possibility of upside for the trader.
Example
If a trader purchases 1,000 shares BP (BP) for $44 each. The trader also creates the option to purchase 10 calls (one contract for each 100 shares) with a strike of $46 and expires within one month. The expense that is $0.25 per share or $25 for each contract and $250 for all 10 options. The $0.25 price reduces the basis of those shares by $43.75 and any decrease in the basis of the shares to this point would be offset by the price paid from the option which provides a limited risk security.
If the share price is over $46 prior to expiration the call option short is granted (or “called off”) and the trader has to sell the shares at the strike price of the option. In this scenario the trader would earn profits from $2.25 for each shares ($46 strike price minus $43.75 price basis).
This implies that the trader doesn’t expect BP to rise over $46 or even significantly below $44 in the coming month. So long as the shares do not go over $46 and then be removed before expiration of the options and the trader keeps the premium in good standing and may continue to sell calls on shares, should they wish.
