One of the confusing things when looking into options is the different types of options that are available. There are call options, put options, exotic, OTC, Vanilla, American, European. Then there are the things within the contract to take into account and agree to such as the strike price, expiration date, premiums.
Understanding the type of option you are looking at and what the key things to be aware of within the option, makes looking at contracts much easier.
There are two classes of options contract, calls and puts.
All option investors would fit into one of these classes. Let’s define them.
Difference Between a Put Option and a Call Option
All those who wish to invest in options would fall into one of these classes, as the class of option determines what action would be taken. In other words, are you going to be buying or selling? By definition, if you have a call option, this means you have the right, but not an obligation to buy according to the agreement set out in the contract. If you have a put option, this means you have the right, but not an obligation to sell according to the agreement set out in the contract.
When it comes to options, there is the possibility of making money when the stock goes down as well as when it goes up.
One of the great things about options is that it is as easy to make money when a stock goes down as well as when a stock goes up. This makes investing in options a versatile investment strategy.
Put Option Explained
When buying a put option is, the first thing to bear in mind is that you are selling and not buying shares.
As investors, we are used to buying shares. On occasion, we sell the shares, but on the whole, we buy more than we sell, especially if you are using a buy and hold strategy with your investments. With put option contracts you are looking to sell the underlying asset at the strike price within the expiry date.
Let us say you want to sell your house in six months time (February) and you are looking for someone to possibly buy it from you. As luck would have it, your neighbour informs you they are looking to buy another property.
You tell your neighbors your plans and say to them you would give them $10,000 which would give you the right to sell the house to them within the next six months for $400,000.
The neighbor accepts the offer, and you have just created a put contract, as all the elements of an option contract have been met.
- The seller – You. A put option gives you the right to sell once the strike price has been met.
- The investor – Your neighbor. There is an obligation for the neighbor to buy the house if the seller exercises the option.
- Strike price – This is the price you have agreed to sell the house
- Expiration date – six months from now (28th February)
- Premium – This is the amount you’ve paid your neighbor to buy the house from you at some point over the next six months for $400,000.
Here is an example of a put option in action using something we would understand.
Exercising A Put Option
In this example, we’ll assume the premium had already been factored into the strike price and will not make it part of the profit/loss figure
Example Scenario 1
If the value of the house in the last month of the option contract is $350,000, you would want to exercise the option as the price agreed with your neighbour, the investor, was higher. Thus you are making money.
Example Scenario 2
Here the market value of the house is the same as the strike price.
You as the home investor exercises the contract as the strike price has been met.
Example Scenario 3
Let us say we are in the last month of the option contract, and the price of the property is now $500,000.
As the value of your house is higher than the option strike price, you would not want to exercise the option and would rather let the option expire.
One thing that is important to be aware of if you are the investor is that you have to be able to purchase the asset if the seller decides to exercise the option.
That is the basics of a put option.
Now you what the types of options are, the difference between put and call option and have been shown with an example showing what a put option is.
With this knowledge, you can create your own options.
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