An option is a contract between a buyer and seller that gives the buyer a choice to purchase or sell financial security; usually stocks at a given price called the ‘strike price’ at a certain point in time. An option is a prediction on the way a stock will move. Buyers are then required to pay the seller a fee called the premium. When the option expires and the stock is worth the strike price, which usually depends on the option type, it’s worth the money.
Options are interesting because of the potential to earn huge returns, though it might come at the cost of risking a significant loss. Option strategies practiced by professionals are designed with an objective to have the time factor work for them.
There are generally two outcomes for options trading, it could be worthless or profiting. If the stock doesn’t follow the buyer’s anticipated move, the option expires worthless and the buyer loses the premium and the seller keeps it. In this case, the seller’s profit is the buyer’s loss. And if things go as planned, then the difference between the strike price and the stock price is the option’s profit. Here the buyer’s profit is the seller’s loss.
Types of option trading:
Depending on the rise and fall of stocks, options are broadly classified into two types, calls and puts. Calls increase in value as the stock rises while as puts increase in value as the stock falls.
Types of option trading strategies:
- Call buying: In this trading option, if the investor is confident about a particular stock and want to limit risk by utilizing leverage to take advantage of rising prices. They allow traders to benefit by risking smaller amounts and leads to the potentially unlimited upside at the cost of the premium.
- Put buying: If you want to take less risk than with a short-selling strategy that utilizes leverage to take advantage of falling prices then a put buying option is going to yield you a lot of profit. This option works just the opposite of a call option.
Short-selling you can profit from falling prices and the risk associated with a short-selling position is unlimited as there is theoretically no limit on how high a price can rise. If the stock rises more than the option’s strike price, the option will simply expire worthlessly with a very high upside at the cost of the premium.
- Covered calls: If you are expecting no change or a slight increase in the underlying’s price of the stock and are willing to limit upside potential in exchange for some downside protection then it’s referred to as a covered call. The Covered call is selling a call when you already own the underlying stock.
- Married put: In this type, an investor purchases a financial asset as well as an option for an equivalent number of shares. This strategy helps in protecting the downside risk when holding a stock. This strategy functions just like an insurance policy when the stock price falls sharply.
It’s better to first understand the technicalities of trading and options related to it, before putting your trading skills to the test. You can go for options trading strategies for beginners before you start risking your own money.