General Tips

An Overview of the Types of Trading Options

While options trading may seem overwhelming in the beginning, understanding it is easy, especially when you are conversant with some core points. Often, investor portfolios are designed with various asset classes such as exchange-traded funds, bonds, mutual funds, or stocks.

Options fall in the asset category and come with numerous advantages that ETFs and stocks do not offer. However, you have to use them correctly to reap the benefits. Read on to understand the different types of options available.

Understanding Options

Options are contracts that allow holders the right to either purchase or sell a specific amount of underlying asset at a preset price before or when the contract expires. However, holders are not under any obligation to do so. Investors can purchase options through a brokerage investment account.

So robust are options such that they can improve an investor’s portfolio through leverage, protection, and increased income. Based on the situation at hand, there will always be an option layout that fits an investor’s objective. A good example, in this case, would be leveraging options as an adequate barrier against a dropping stock market to lessen potential losses.

Apart from generating recurring income, options usually come in handy in speculative conditions like predicting a stock direction. Worth mentioning is that nothing comes for free with bonds, stocks, or even options. Options trading is also prone to various risks that investors should understand before initiating a trade.

Types of Options

There are two common types of options as we shall see below.

·         Call Options

When it comes to call options, investors have the right but not the obligation to purchase the fundamental asset when the option contract’s preset price is achieved. Investors purchase calls when they are convinced that the underlying asset’s price will rise and sell when they predict a drop in the price.

·         Put Options

Put options give the bearers a right without obligating them to sell the fundamental asset when the predetermined contract price strikes. The put option seller is liable to purchase the asset should the buyer exercise their option. Investors purchase puts when they are convinced that the underlying asset price will drop and sell when they predict a price increase.

Options Payoffs for Puts and Calls

·         Calls

Call option buyers pay the option fee fully when committing to the contract. Later, the buyer is likely to enjoy a profit if the markets fluctuate in their favor. The option cannot generate a bigger loss than the buying price, a key advantage of purchasing options. In the case of limited investment, investors obtain unlimited profit power with a strictly restricted and accepted possible loss.

Suppose the underlying asset price does not surpass the option’s preset price before its expiry an investor will lose the amount they invested in the option. However, suppose the underlying asset price surpasses the strike price the call buyer will make a profit. The total profit is the difference between the option’s strike price and the market price multiplied by the underlying asset’s incremental value, and minus the option price.

Disposing of Call Options

Call option sellers experience possibly unlimited drawbacks. As the underlying asset’s spot price surpasses the strike price, the option seller gets a loss similar to the option purchase’s profit. However, if an underlying asset’s market price does not surpass the option strike price the option will expire with no value. The option seller will gain profit from the premium amount they acquired for the option.

·         Puts

A put option permits buyers to dispose of an underlying asset at the predetermined option price. The profit a buyer earns from the option is based on how much the spot price drops below the predetermined set price.

Suppose the spot price falls below the strike price, the put buyer will be in-the-money (can purchase the asset below its prevailing market price.) Suppose the spot price is higher than the predetermined price the option expires unexercised.

An option buyer’s loss, in this case, is restricted to the option fees paid. The put seller will be out-of-the-money (the underlying asset will be trading below the call’s predetermine price)

Applications of Call and Put Options

·         Purchasing Puts or Hedging

Suppose an investor predicts a price drop in some stocks within their portfolio and they are not ready to leave their positions in the long term, they can purchase options on the stock. If the stock price drops, profits in the puts offset losses in the existing stock. Investors can leverage this strategy in case of uncertainty. While mutual fund managers usually leverage puts to limit the fund’s risk exposure.

·         Purchase or Sell Puts

Suppose an investor predicts an increase in a security price they can sell puts or purchase calls to gain from the price increase. By purchasing call options the investor limits their total risk to the option fees paid, exposing them to unlimited possible risk.

Finally

Once you understand the basic concepts of options you will have an easier time understanding them. Remember, when you use them correctly, options can offer opportunities and become harmful when used incorrectly.