Introduction
It refers to trading financial options as one of the financial market tools, so here is a simplified explanation.
What are Options?
They are financial contracts that give the buyer the right (but not the obligation) to buy or sell an asset (such as stocks, commodities, currencies) at a predetermined price (Strike Price) on a specified date (Expiration Date).
Options are of two types:
1. Call Option: The right to buy an asset at a specified price.
2. Put Option: The right to sell an asset at a specified price.
How does trading work?
- The buyer pays a premium to the seller in exchange for the right.
- The seller is obligated to fulfill the contract if the buyer decides to exercise the option. An example of this is:
- I bought a **Call Option** for XYZ stock with a strike price of $100 that expires in a month.
- If the stock price rises to $120, you can buy it at $100 (Profit = $20 - premium).
- If the stock declines, you can abandon the option (your loss = the premium only).
Why do people trade options?
1. Hedging: Protecting the portfolio from market volatility (example: buying a Put Option to hedge against stock declines).
2. Speculation: Making profits from expected price movements (up or down).
3. Generating income: Such as selling Covered Calls on owned stocks.
Key Terms:
- Premium: The cost of buying the option.
- Intrinsic Value: The difference between the market price and the strike price (for options 'in the money').
- Time Value: A portion of the premium that depends on the time remaining until the option expires.
- In the Money (ITM): The option is profitable if exercised now.
- Out of the Money (OTM): The option is currently not profitable.
Common Strategies
1. Covered Call: Selling a call option on shares you own (to generate additional income).
2. Protective Put: Buying a put option to hedge against a decline in a stock you own.
3. Straddle: Buying a Call and Put at the same price and strike (if expecting sharp volatility).
4. Iron Condor: A complex strategy that combines selling and buying options to profit in a narrow price range.
Risks
- Unlimited risk for the seller: If the seller is uncovered (example: selling an uncovered Put).
- Total Premium Loss: For the buyer if the options expire out of the money.
- Rapid Volatility: Options are sensitive to changes in price, time, and volatility.
Tips for Beginners:
1. Study the basics well (like Greeks: Delta, Gamma, Theta, Vega).
2. Start with simple strategies (like Covered Calls or Protective Puts).
3. Use a demo account before trading real.
4. Avoid naked selling unless you are a professional.