Options are misunderstood because it seems like they're complicated and risky, but the reality is that options can be very useful for anyone - even if you never had any trading experience. Of course if you're just getting started, you should probably check out this article on the what is the best Options Trading Books For Beginner.
There's no mystery behind them! All one needs to do in order trade confidently with this type of financial instrument is know their basic characteristics: what each option represents; how much risk an investor may take on when buying or selling these contracts at different prices within a certain time period (or expiring); etcetera... Once someone understands those things thoroughly then he/she will have gained enough knowledge so as not feel intimidated by anything else involved with being exposed both sides during any given market environment. We're going to learn all that and much more in just a few moments, so let's get started!
First of all, it's important for one to understand that there are two types of options: calls and puts. They each represent unique risks and rewards relative to the price movement of the underlying financial product. With this understanding we can move on and discuss how these work...
When someone goes long (buys) an option they're taking a bullish position because they do believe that the market is going up; however, the buyer must be careful as he/she limits his risk either with stops (meaning orders to sell - which I'll explain later) or by purchasing protective options such as "puts" or insurance contracts. On the other hand, someone who goes buys a put (goes short) it's because he/she thinks that the market is going to move down within a specific time frame; however, that person must also be careful as they can lose more money than what they initially expected so it's always best to purchase "calls" which are insurance contracts.
Now it's time to get into some specifics... You should know by now what all options represent but if not, then check out my article on this subject by clicking here . That being said, let's go over all of the basic characteristics of calls and puts:
· Call options - buy these when you think the price of an underlying asset will go up relatively soon. When you buy even one contract of a call at strike A, you're in essence saying that the price will go up over 50% during the duration of the contract. You are NOT obligated to purchase anything if you buy a call option.
· Put options - when someone goes long on puts they are taking bearish position because they believe that the price of an underlying asset will fall relatively soon. When buying just one contract at strike B, you're essentially saying that the price will go down over 50% by expiration (time is ticking).
· Both calls and put options expire within a certain time period (always listed alongside each one) which means that if your stock didn't reach your desired direction get out.
· Options contracts are "for 100 shares" which means that if you buy one contract at $4.50 for example, then you must transact $450 (plus commissions of course). If the stock price goes up by 10% - within your desired time frame - then you'll make $45 on your investment (minus commission fees of course) but it's important to mention that buying options does not provide dividends or voting rights like owning stocks do . You can read this article on the timing of dividend payouts with stocks vs. options; let's get back to what we were discussing though...
· An option allows an investor to have control over a certain number shares in a company when they buy a contract. You've probably seen this before when an investor says that he/she will use their 100 shares in company X to vote, well they can do the same with options contracts relative to a certain number of shares within an underlying asset.
· A call option increases in value as the price of the underlying stock goes up at expiration (time is ticking); conversely, puts increase in value as the price moves down at expiration .
· When you buy calls your risk is limited because theoretically you cannot lose more than what you spent on the contract, but if things go wrong than you may lose all or some of your investment so it's important to "protect" your portfolio by buying protective puts. On the other hand, when you buy puts your risk is theoretically unlimited because if the price moves down to $0 at expiration than all you've lost is the amount that you initially spent on the contract.
· Although it depends on how much you paid for a call or put, once an option contract expires and it's "time is up" than there is no credit given back from the brokerage firm to those who bought contracts. In other words, if someone buys a call or put then they'll have to pay for 100 shares within that particular company whether their investment was profitable or not! That being said it's always best practice to purchase options as insurance against a strong downward move in order to mitigate large losses...
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