How Options Trading Works: The Basics
Many investors put their money in stocks, bonds, and mutual investments, but another type of security worth trying in some cases is an option, which is ideal for investors who have a solid understanding of the practical uses and risks associated with this type of investment.
When to Engage in Options Trading
Options’ strength is in their versatility, along with the fact that they can interact with other more traditional assets such as good option stocks. You can easily adapt or change your position based on a wide range of situations that can come up.
For example, they may be used as a hedge against a declining stock marketing to put a limit on downside losses. Options can be used for speculation or be as conservative as you want them to be.
Even if you never use options, it’s important to have a basic understanding of how other companies may use them.
What Exactly Are Options?
Specifically, options are a kind of derivative security because of the linking between the option’s price with that of something else. They’re essentially contracts that grant the ability to buy or sell an underlying asset at a specific price that falls on or before a set date. Options that you can buy are referred to as call options, while the right to sell is called a put option.
Call options are essentially deposits for use in the future. For instance, as a land developer you might want to be able to purchase a vacant lot to build something on in the future, but only want to do it if specific zoning laws are in place.
You could then buy a call option from the lot owner to purchase it at around $250,000 within the next three years. However, the developer needs to pay a premium to secure that purchase, which will likely be several thousand dollars.
When the developer finally purchases the land at the set price within the three-year period, the land could be worth double that. However, if the purchase doesn’t work out within those three years and the option expires, the developer will need to pay market price for the land, while the landowner keeps the $6,000 premium regardless.
Put options, on the other hand, are similar to insurance policies. Using a similar scenario as the one above, let’s consider an instance where the land developer owns a big portfolio of blue chip stocks and is currently worried that there could be a recession in two years’ time.
He’ll want to ensure the portfolio doesn’t experience a loss of more than a small percentage of its value. He can buy a put option if the S&P 500 is trading at 2500, which allows him to sell the index at 2250 at any time within the next couple of years.
If the market experiences a crash by 20%, worth 500 points, the developer will have made 250 points through the right to sell the index at 2250 while it’s trading at 2000, which equates to a total loss of 10%.
While there is much more to options, these are some of the fundamentals to consider that may encourage you to engage in options trading.