Simple (But Important) Things To Remember About Options

What are options?

Options are financial securities just like stocks or bonds. It constitutes a contract with strict terms and conditions. An option contract gives the buyer the right to buy or sell the underlying asset at a fixed price on or before a set date. Moreover, this security is a type of derivative as it derives its value from an underlying asset.

No one has seen options that have been so popular before. Last year was a very successful year for options trading. People worldwide traded 7.5 billion options (53% rise from last year) in 2020 while people traded 4.9 billion in 2019.

What are call, put options and premium?

There are two types of options: “put” options and “call” options. You may want to buy “a call option” if you expect the price of the underlying to rise within a specified time frame. On the other hand, you may buy a put option if the price of the underlying is expected to decline within a certain time frame.

The price that you pay to buy this type of contract is known as premium. Generally, an options contract represents 100 shares of the underlying security such as stock, bond, currency and others. Definitely, you will have to pay a premium service fee for each contract you buy. For instance, if an option premium is 35 cents per contract, purchasing one option will cost $56 ($0.56 x 100 = $56). You can understand that the premium to some extent is based on the strike price (the price for buying or selling the security until the expiration date).

Another important factor in the premium price to consider is the expiration date. When you buy eggs or milk, usually there is a written expiration date that shows the day the option contract expires. You can also use the underlying asset according to the given date. Let’s take stocks example. That is, stocks usually reach the expiration date on the third Friday of the contract’s month.

Why do some investors prefer options over stocks or bonds?

The main reason behind people’s preference for this security is lower cost. In this type of security, you can take control of the same number of shares with much less money.
Another reason is the likelihood of greater potential gains through intelligent math of leverage.

However, options trading may be overwhelming unless you consider the following risks it has:

  • Complexity. Traders believe that options are more complex than other traditional investments such as stocks.
  • Time. You must be careful at timing since this type of securities can expire.
  • Leverage. This can be both risky and advantageous. Leverage can hurt and help.

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