Options are financial contracts that give the holder the right to buy or sell a financial instrument at a specific price for a certain period of time. Options are available for numerous financial products, such as stocks, funds, commodities, and indexes. Like most other asset classes, options can be purchased with brokerage investment accounts.

Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, exchange-traded fu🐓nds (ETFs), and mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.

There are three key features of options:

• Strike price: This is the price at which an option can be exercised.
• Expiration date: This is the date at which an option expires and becomes worthless.
• Option premium: This is the price at which an option is purchased.

Why Trade Options?

Options are powerful because they can enhance an individual’s 澳洲幸运5官方开奖结果体彩网:portfolio, adding income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal.

Options can be used as a hedge against a declining stock market to limit downside losses. In fact, options were really invented for hedg🦋ing purposes. Hedging ཧwith options is meant to reduce risk at a reasonable cost. Just as you insure your house or car, options can be used to insure your investments against a downturn.

Imagine that you want to buy technology stocks, but you also want to limit losses. By using put options, you could limit your downside risk and cost-effectively enjoy all the upside. For 澳洲幸运5官方开奖结果体彩网:short sellers, call options can be used to limit losses if the underlying price moves against their trade—especially during a 澳洲幸运5官方开奖结果体彩网:short squeeze.

Options can also be used for speculation. 澳洲幸运5官方开奖结果体彩网:Speculation is a wager on future price direction. A speculator might think the price of a stock wil🧜l go up, perhaps based on f🐭undamental analysis or technical analysis.

A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders because opti♛ons provide leverage. An out-of-the-money call option may only cost a few dollars or ev💞en cents compared with the full price of a $100 stock.

How to Trade Options

Many brokers today allow access to options trading for qualified customers. If you want access to options trading, you will have to be approved for both margin and options with your broker.

Once approved, there are four basic things you caꦜn do with options:

1. Buy (long) calls
2. Sell (short) calls
3. Buy (long) puts
4. Sell (short) puts

Buying stock gives you a long position. Buying a call option💃 gives you a potential long൲ position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.

Buying a put option gives you a potential short position in the underlying stock. Selling a naked or unmarried put gives you a potential long position in the underlying stock. Keeping these four sce𓆉narios straight is crucial.

People who buy options are called holders, and those who sell options are called writers of options. Here is the 🌟impoꦦrtant distinction between holders and writers:

1. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
2. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in the money. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more—and in some cases, unlimited—risks. This means writers can lose much more than the price of the options premium.

Options can also generate recurring income.🦂 Additionally, they are often used for speculative purposes, such as wagering on the direc🐎tion of a stock.

Note that options trading usually involves trading commissions—often, a flat per-trade fee plus a smaller amount per contract—for instance, $4.95 + $0.50 per contract.

How Do Options Work?

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option that profits from that event would be. For instance, a call value goes up as the stock (澳洲幸运5官方开奖结果体彩网:underlying)🔴 goes up. This is the key to understanding the relative value of options.

🥂The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a w🐭asting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day.

Because time is a component of 澳洲幸运5官方开奖结果体彩网:the price of an option, a one-month option ♔is going to be less valuable than a three-month option. This is because with more time avai🎶lable, the probability of a price move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is known as 澳洲幸运5官方开奖结果体彩网:time decay. The same o🐼ption will b♔e worth less tomorrow than it is today if the price of the stock doesn’t move.

Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibility of substantial move🐬s both up and down.

Greater price swings will increase𓄧 th꧃e chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.

On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.

The majority of the time, holders choose to take their profits by trading out (closing out) their position. This means tha🍰t option holders sell their options in the market, and writers buy their 🌄positions back to close.

According to the Cboe, over the long term, more than seven in 10 option contracts are closed out before expiring, about another two in 10 expire without value, and about one in 20 get exercised.

Fluctuations in option prices can be explained by 澳洲幸运5官方开奖结果体彩网:intrinsic value and 澳洲幸运5官方开奖结果体彩网:extrinsic value, whꦦich is also known as time value. An option’s premium is the combination of its intrinsic val⛎ue and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading.

Time value represents the ad🥂ded value an investor has to pay for an option above the intrinsic value. This is the extrinsic value or time value. 🔯So the price of the option in our example can be thought of as the following:

In real life, options almost always trade at some level above their intrinsic value, because the probability 🦄of an event occurring is never absolutely zero, even if it is highly unlikely.

Types of Options: Calls and Puts

Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an 澳洲幸运5官方开奖结果体彩网:options contract, 𒀰it grants you the right but not the obligation to buy or sell an underꦐlying asset at a set price on or before a certain date.

A 澳洲幸运5官方开奖结果体彩网:call option gives the holder the right to buy a stock, and a 澳洲幸运5官方开奖结果体彩网:put option gives the holder the right to sell a stock. Think of a call ꦇoption as a down payment on a future purchase.

Call Options

A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. A call option will therefore become more valuable as the underlying secur𒁏ity rises 🍷in price (calls have a positive delta).

A long call can be used to speculate on the price𓃲 of the underlying rising sinceꦓ it has unlimited upside potential, but the maximum loss is the premium (price) paid for the option.

Call Option Example

A potential homeowner sees a new developm🐽ent going up. That person may want the right to purchase a home ⛦in the future but will only want to exercise that right after certain developments around the area are built.

The potential homebuy🌟er would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at, say, $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit.

Naturally, the developer wouldn’t grant such an option for free. The potential homebuyer needဣs to contribute a down payment to lock in that right.

With respect to an option, this cost is known as the premium. It is the price of the option contract. In 𝐆our home example, the deposit might be $20,000 th🔯at the buyer pays the developer.

Let’s say two years have passed, and now the♏ developments are built and zoning ha😼s been approved. The homebuyer exercises the option and buys the home for $400,000 because that is the contract purchased.

The market value of th൲at home may have doubled to $800,000🤪. But because the down payment locked in a predetermined price, the buyer pays $400,000.

Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the homebuyer must pay the market price because the contract has expired. In either case, the developer ♏keeps the original $20,000 collected.

Put Options

Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the underlying stock at the strike price on or before expiraꦰtion.

A long put, therefore, is a short position in the underlying security, since the put gains value as the underlying price falls (they have a negative delta). 澳洲幸运5官方开奖结果体彩网:Protective puts can 🌞be purchased as a sort of insuranc💫e, providing a price floor for investors to hedge their positions.

Put Option Example

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with the process of pur꧒chasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage.

They pay an amount called ꦰa premium for a certain amount of time—let’s say a year. The policy has a face value and gives the insurance holder protection in tꦚhe event the home is damaged.

What if, instead of a home, your asset was a stock or inde🌳x investment? Similarly, if an investor wants insurance on their S&P 500 index portfolio, they can purchase put options.

An investor may fear that a bear market is near and may be unwilling to lose more than 1𒆙0% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2,500, they can purchase a put option giving them the right to sell the index at $2,250, for example, at an💝y point in the next two years.

If in six months the market crashes by 20% (500 points on the index), they🍸 have made 250 points by being able to sell the index at $2,250 when it is trading at $2,000—a combined loss of just 10%.

In fact, even if the market dro💞ps to zero, the loss would ಌonly be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.

Uses of Call and Put Options

Call options and put options are used in a variety of situations. The table below outlines some use cases for call and put options.

Examples of Trading Options

Call options and put options can only function as effective hedges when they limit losses and maximize gains. Suppose you’ve purchased 100 shares of Company XYZ’s stock, betting 🌺that its price will increase to $20.

Therefore, your total investment is $1,000. To hedge against the risk that the price might decline, you purchase one put option (each options contract represents 100 shares of the unde🀅rlying stock) with a strike price of 10, each wor🎀th $2 (for a total of $200).

Consider the situation when the stock’💮s price goes your way (i.e., it increases to $20). In such a scenario, your put options expire wort꧅hless. But your losses are limited to the premium paid (in this case, $200).

If the price declines (as you bet 𓄧it would in your put options), then your maximum gains are also capped. This is because the stock price cannot fall below zero, and therefore, you cannot make more money than the amount you make after the stock’s price falls to zero.

Now, consider a situation in which you’ve bet that XYZ’s stock 💫price will decline to $5. To hedge against this position, you’ve purchased call stock options, betting that the stock’s price will increase to $20.

What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s price after it takes off. T𝔉heoretically, XYZ can go all the way to $100,000 or higher. Therefore, your gains are not capp🍬ed and are unlimited.

The table below summarizes gai💎ns and losses for options buyers.

Using Long Calls

As the name indicates, going long on a call involves buying call op✃tions, betting that the price of the underlying ass🤡et will increase with time.

For example, suppose a trader purchases a contract with 100 call options for a stock that’s currently trading at $10. Each option is priceꩵd at $2. Therefo🤪re, the total investment in the contract is $200. The trader will recoup her costs when the stock’s price reaches $12.

Thereafter, the stock’s gains are profits for her. There are no upper💟 bounds on the stock’s price, and it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2.

Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the options expire worthless and the trader loses only $200. Long calls are useful strategies for investors when they are reasonably certain that a given stock’s🙈 price will increase.

Writing Covered Calls

In a short call, the tr♓ader is on the opposite side of the trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame.ꩵ

But 澳洲幸运5官方开奖结果体彩网:writing a naked call—without owning actual stock—can also mean unlimited losses for the🅷 trader becau༺se, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.

A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its pr🥃ice goes in the opposite direction. Thus, a covered call limits losses and gains because the maximum 🐬profit is limited to the amount of premiums collected.

Covered calls writers can buy back the options when they are close to in the money. Experien💦ced traders use covered calls to generate income from their stock holdings and balance out tax gains made from other trades.

Long Puts

A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a t🀅rader purchases a one 10-strike put option (representing the right to sell 100 shares at $10) for a stock trading at $20.

Each option is priced at a premium of $2. Therefore, the total inves🦹tment in the contract is $200. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike - $2 premium).

Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the stock’s price cannot fall below zero. The losses are also capped because the trader ca🌳n let the options expire worthless if prices move in the opposite direction.

Therefore, the maximum losses th꧃at the trader will experience are limited to the premium amounts paid. Long puts are usꦐeful for investors when they are reasonably certain that a stock’s price will move in their desired direction.

Short Puts

In a short put, the trader will write an option betting on a price increase and sell it toꦏ buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. However, the maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise th🧸eir option.

Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money💜 and generates income thrꦛough the premium collected.

Combinations

The simplest options position is a long call (or put) by itself. Th𝓀is position profits if the price of the ꧑underlying rises (falls), and your downside is limited to the loss of the option premium spent.

If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle. This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively st🍌able, you lose the premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure in which direction.

Basically, you need the stock to move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is al🎉so less expensive than a 💛straddle.

On the other hand, being 澳洲幸运5官方开奖结果体彩网:short a straddle or a🥃 strangle (selling both ꦗoptions) would profit from a market that doesn’t move much.

Spreads

Sprea🧸ds use two or more options positions of🐽 the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared with a single options leg. There are many types of spreads and variations on each. Here, we just discuss some of the basics.

澳洲幸运5官方开奖结果体彩网:Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike. A bull call spread, or澳洲幸运5官方开奖结果体彩网: bull call vertical spread, is created ✨by ꩲbuying a call and simultaneously selling another call with a higher strike price and the same expiration.

The spread is profitable if the underlying asset increases in price, but the upside is limite🦩d due to the short-call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.

Similarly, a 澳洲幸运5官方开奖结果体彩网:bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a 澳洲幸运5官方开奖结果体彩网:calendar spread or time spread.

A 澳洲幸运5官方开奖结果体彩网:butterfly spread consists of options ♊at three strikes, equally spaced apart, wherein all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor—the difference is t𒀰hat the middle options are not at the same st𒈔rike price.

Synthetics

Combinations are trades constructed with both a call and a put. There is a special type of combination known as a 澳洲幸运5官方开奖结果体彩网:synthetic. The point of a sౠynthetic is to create an options position that behave🎃s like an underlying asset but without actually controlling the asset.

Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to creat﷽e a synthetic position using options. For instance, if you buy an equal amount of calls as you sell puts at the same strike and expiration, you have created a synthetic long position in the underlying.

Boxes are another example of using options in this way to create a synthetic loan, an options spread that effectively behaves like a zero-coupon bond until it expires.

The Bottom Line

Options do not have to be difficult to understand when you grasp their 澳洲幸运5官方开奖结果体彩网:basic concepts. Options can 澳洲幸运5官方开奖结果体彩网:provide opportunities when used correctly and can be harmful when used incorreꦿctly. If you’re ne💫w to the options world, take your time to understand the intricacies and practice before putting down serious money.

Correction—Oct. 24, 2024: This article has be𝐆en corrected to state that writing a naked call—without ownin🐬g actual stock—could lead to unlimited losses for a trader.