How To Understand The Stock Market – Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios typically consist of several asset classes. These can be stocks, bonds, ETFs and mutual funds.
Options are another asset class that, when used properly, offer many advantages that trading stocks and ETFs alone cannot.
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Options are contracts that give the right — but not the obligation — to buy or sell an amount of an underlying asset at a predetermined price on or before the contract expires. Like other asset classes, options can be purchased through brokerage investment accounts.
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Options are powerful as they can enhance an individual’s portfolio. They do this through additional income, hedging and leverage. Depending on the situation, there is usually a scenario option that suits the investor’s objective. A popular example is using options as an effective hedge against stock market falls to limit losses. In fact, options were really invented for hedging purposes. Option hedging aims to reduce risk at a reasonable rate. Here you can think about using options like insurance policy. Like insuring your home or car, options can be used to insure your investment against a downturn.
Imagine you want to buy a technology stock, but you also want to limit your losses. By using put options, you can limit your risk and enjoy all the benefits in a profitable manner. Short sellers can use call options to limit losses if the underlying price changes relative to their trade – especially during a short squeeze.
Options can also be used for speculation. Speculation is a bet on the future direction of prices. A speculator may think that a stock’s price will rise, perhaps based on fundamental analysis or technical analysis. A speculator can buy a stock or buy a call option on a stock. Speculating with a call option — rather than buying the stock outright — is attractive to some traders because options provide leverage. An out-of-the-money option costs a few dollars or cents compared to the full price of a $100 share.
Options belong to a larger group of securities known as derivatives. The price of a derivative depends on the order of the price of something else. Options are derivatives of financial securities – their value depends on the price of another asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities.
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In terms of valuation of option contracts, it is mainly about determining the probability of future price events. The more likely something is to happen, the more expensive the option to profit from that event will be. For example, the value of a call increases as the stock (the underlying) increases. This is the key to understanding the relative value of options.
The shorter the time until expiration, the lower the value of the option. This is because the price of the underlying stock is less likely to change as it gets closer to expiration. This makes an option a liquidating asset. If you buy a one-month option and are out of the money and the stock doesn’t move, the value of the option decreases each day. Since time is an integral part of the option price, a one-month option will have less value than a three-month option. This is because the more time you have, the more likely the price will move in your favor and vice versa.
As a result, the same reminder that expires in a year will cost more than the same reminder in a month. A waste of these options is the result of the decay of time. If the stock price does not move, the same option will be worth less tomorrow than it is today.
Volatility also increases the price of the option. Because uncertainty increases the probability of an outcome. If the underlying asset’s volatility increases, high price swings increase the likelihood of significant moves up and down. Larger price fluctuations increase the likelihood of an event occurring. Therefore, the higher the volatility, the higher the option price. Option trading and volatility are intrinsically linked to each other in this way.
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On most US exchanges, a stock contract is an option to buy or sell 100 shares; So you multiply the contract premium by 100 to get the total amount you have to spend to buy the call.
In most cases, owners decide to take their profits by selling (closing) their position. This means option holders sell their options in the market and writers buy back their positions. Only about 10% of options are exercised, 60% are traded (closed), and 30% are worthless.
Fluctuations in option prices can be explained by intrinsic value and extrinsic value, also known as time value. An option’s premium is a combination of its intrinsic value and time value. Intrinsic value is the amount in the money of the option contract, which, for a call option, is the amount above the exercise price at which the stock trades. Time value represents the additional value an investor must pay for an option above its intrinsic value. This is the extrinsic value or time value. Therefore, the option price in our example can be calculated as:
In real life, options almost always trade at some level above their intrinsic value because the probability of an event is never completely zero, even if it is highly unlikely.
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Options are a type of derivative security. An option is a derivative because its price is inherently linked to the price of something else. If you buy an option contract, it gives you the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before a certain date.
All options give the owner the right to buy a stock, and a put option gives the owner the right to sell a stock. Think of the call option as a down payment for a future purchase.
Options involve risks and may not be suitable for everyone. Option trading is speculative in nature and carries significant risk of loss.
A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. So a call option becomes more valuable as the underlying security rises in price (calls have positive delta).
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A long call can be used to predict an increase in the underlying price because it has unlimited upside potential, but the maximum loss is the premium paid for the option (the price).
A potential homeowner sees a new development being developed. The person may want the right to buy a house in the future but wants to exercise that right only after building some amenities in the area.
A potential home buyer will benefit from the option to buy or not. Imagine that I can buy a call option from the developer to buy a house for $400,000 anytime in the next three years. Well, I can – you know it as a non-refundable deposit. Of course, the developer will not provide such an option for free. A potential home buyer is required to make a down payment to lock in that lien.
With respect to an option, this cost is known as the premium. That is the price of the option contract. In our home example, the buyer’s deposit to the developer might be $20,000. Let’s say two years have passed and now the works have been built and the zoning has been approved. The home buyer exercises this option and buys the home for $400,000 because it is a purchase contract.
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The market value of that home may have doubled to $800,000. But since the down payment is paid at a predetermined price, the buyer pays $400,000. Now, in an alternative scenario, let’s say the zoning approval doesn’t come until the fourth year. This is one year after the option expires. As the contract has expired, now the home buyer has to pay the market price. In either case, the developer keeps the original $20,000 raised.
Unlike call options, a put gives the holder the right, but not the obligation, to sell the stock at the strike price on or before expiration. A long put is a short position in the underlying security because the put gains value as the price of the underlying falls (they have a negative delta). Protective puts can be purchased as a form of insurance, providing investors with a price floor to protect their positions.
Now think of a put option as an insurance policy. If you own your home, you’re probably familiar with the process of purchasing homeowner’s insurance. A homeowner purchases a homeowner’s policy to protect their home from damage. For a year, they pay an amount called premium for a fixed period of time. The policy has a nominal value and covers the insured in case of damage to the home.
Instead of a house, what if your property is a stock or index investment? Similarly, if an investor wants insurance on his S&P 500
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