Types of Options Explained
Over recent years, investing in the trading industry has become more accessible to many thanks to the proliferation of online trading platforms. And as in many fields, you can implement various strategies to help you capitalise on your chances in the markets. For instance, investing in companies’ stocks using options is quickly gaining traction and allowing many traders to reach their objectives.
An option is a derivative tool that buys you the right but not the obligation to buy or sell its underlying instrument by a set period and price. They are also cheaper than purchasing the instrument because they don’t entail ownership of the assets but derive their value from their price movement, making them risky. But if you need help understanding options, this piece will highlight what they are and the different kinds.
What are Options?
An option is a speculative instrument predicated on the price movement of its underlying assets. Furthermore, it gives the holder the right but not the obligation to exercise their right to buy or sell the underlying assets at a specified time and price. An option’s stated price is referred to as the strike price, and you find them on some of the best options trading platforms.
A contract usually involves a seller and a buyer paying a premium for exercising it. Conversely, an options contract is a derivative tool that allows you to leverage your position because it costs a fraction of the asset’s price. However, this also means you don’t get to own the underlying assets. Instead, you speculate and subsequently benefit from its price movement in the market.
This makes options an excellent hedging tool that reduces your capital needs and allows you to hold a more diverse and less risky portfolio. Furthermore, options reduce your exposure only to your premium while keeping your upside wide open. The most essential statistics to keep your eye on when trading options are the daily trading volume and the market’s open interest.
One more thing to note about options is that American options allow buyers to exercise their contract anytime before or during its expiry date. While in contrast, European options only allow you to exercise your contract on their expiry dates- an interesting differentiation between the two markets.
Types of Options
A call option gives you the right but not the obligation to buy the contract’s underlying instrument at a specified price and date. Call options become more valuable as their underlying instruments’ value rises, giving them a positive delta. They are worth more the longer it takes them to reach their expiry, as it increases the chances of their price rising.
This also means that the more likely an event affecting an instrument’s value positively is to occur, the more expensive the call option becomes.
In addition, call options reduce your maximum loss to the premium you pay to exercise them while leaving your profit potential limitless. For instance, say there is a new development around your area, and you would like to invest in one apartment unit, but only after establishing certain facilities. If the apartment costs $300,000, you can pay the developer a non-refundable deposit or option premium of 10% of its value to hold the right to purchase it by the end of the next four years at the same price.
Now say by the end of the next three years, the developer has put up the facilities you were hoping for, which has also increased the value of the apartments. You can exercise your option to buy your unit at the initial agreed-upon price.
A put option is a speculative tool that gives you the right but not the obligation to sell the contract’s underlying instruments at a set price and date. Put options gain value as the prices of their underlying instruments fall, giving them a negative delta. As an investor with an expensive and risky portfolio, you can use protective puts to hedge against market dips by establishing a price floor. Or an insurance policy of some sort.
For instance, if you’re an investor worried about a bear market washing away your portfolio, you can purchase a put option that limits your losses to a known percentage. Say 10% of $100,000 of your portfolio’s value.