If you have taken a look at our quick reference guide to options investing and still are not sure what options are, or how to use them for investing, you are in the right place. Options can be very tricky to understand and to use properly, and it is important to understand the basics before utilizing day trading options. Keep in mind the same as with other investment advice that it is simply advice, and you are responsible for determining what levels of risk you are willing to take, especially when it comes to investing in options.
Types of Options
Learning about options does not have to be a maze. There are two basic types of options, calls and puts. Similar to other financial investments, there are two sides to every transaction, the buyers and the sellers. Each side takes a position on the option based on their own risk and reward profiling. The party that is purchasing the position, either the call or the put option, is under no obligation to exercise their options, only giving them the ability to exercise them on or by the expiry date. The sellers, also known as writers, are fully obligated for their actions on the options if the buyer exercises their options. For this, writing options is inherently more risky, however that does not make buying options any less risky.
A call option gives an individual or entity the ability to purchase the investment, typically a stock, at a predetermined price known as the strike price, by or at a specific date, known as the expiry. With the two sides of each transaction in mind, the writer or seller of the call is under obligation to sell the shares to the buyer if they decide to exercise the option. The buyer has to determine when the option expires if they want to purchase the shares at the agreed strike price, or let the option fall away.
In an example, an investor is interested in purchasing a call option for XYZ Corp., a fictitious company that’s stock is currently trading at $18.00 a share. They believe that the shares will increase in 3 months, well above $20.00 a share. They can put in an offer for an option for a $20.00 strike price with an expiry 3 months from now. The write of that call believes the price won’t exceed $20.00 a share within 3 months, and takes that option. In 3 months, the buyer must then determine if they exercise the option for $20.00 a share, and if they do, the writer is legally bound to sell the contracted upon shares at the strike price of $20.00.
A put option differs in that the buyer is taking the option to sell the investment at a predetermined strike price until or on the expiry date. The purchaser of a put option is expecting to sell the shares at the expiry date at a higher price than the investment is currently trading at. The put writer is obligated to purchase the investment at that price if the buyer decides to exercise their option.
Back to XYZ, the investor believes that the price will not be increasing to $20.00, but instead will drop from their current listing of $18.00 a share. They invest in a put option to sell the shares at $17.00 a share over the next 3 months, expecting either the market to devalue the company, an economic slowdown or their financials to be not as strong as expected. When the expiry date comes, they will then decide to exercise the option and be able to sell the stock at $17.00 a share, in which case the writer is obligated to purchase the amount of stock at that price.
When to Use Options
In either case, a buyer expects a certain outcome to transpire and the price of an investment to either increase or decrease over a certain period of time. In these cases, they decide to invest in options to exploit the potential gain or loss they expect. If they expect an investment to increase, they would want to invest in buying call options, or even test the ideas of writing put options if they expect a longer term play than someone is offering. If they expect the investment to decrease in value, they first would want to place a put option on the investment, or again, think about writing call options if they believe there is a longer possibility of the stock decreasing.
Options fluctuate in their pricing daily, as with regards to the movements of the investment in pricing. A call price will rise as the shares do, because there is a greater likelihood that the call option will hit the strike price. A call writer is expecting the price to decrease, stay the same, or not increase above the amount of the strike price by the expiry date. Put prices will rise as the investment decreases in value, due to the greater likelihood of the put reaching the strike price. Similarly, put writers are expecting the investment price to either increase, stay the same, or decrease not as low as the put option by the expiry date.
Ready for More Information
You should now have the basic information about how to invest in options by understanding what options are, the positions for each option, and why you would want either position. Remember, calls are the option to buy an investment at a specific strike price on or before the expiry date. Puts are the opposite as they are the option to sell an investment at a specific strike price on or before the expiry date. You can use both to your advantage, and can even use them to offset one and other to secure a financial gain, and we will get into that more in the 6 Options Investing Strategies You Should Know.
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