Options Trading Basics – A Review
- Options give the investor the right to buy or sell the underlying asset or instrument.
- If you buy options, you are not obliged to buy or sell the underlying asset, you just have the right. Meaning, you can choose to buy the options, sell the options or do nothing and let it expire, depending on what is most advantageous to your position.
- Options are either call or put. Call options give the power to the buyer to buy the options. Put options give the buyer the right to sell the options.
- Options are quoted per share, but are sold in 100 share lots. Meaning, if the investor purchases 1 option, he or she is buying 100 shares.
- The investor only has to pay the option premium and not the total amount of shares like if you are buying per stock. For example, if the option premium of a $50 stock is $3, the total amount of the contract is $300 per option. So if the investor is buying 3 options at $3 per option, since he or she is buying in 100 share lots, the total payment would be $900 (3 options x 100 shares per option x $3 option premium).
- Buying shares is different. You have to pay per share. For example, the stock price of Company A is $80. If you want to buy 100 shares, you would have to pay $8,000. Whereas with options, if you wish to invest on 100 shares, you just have to enter into a contract wherein you would buy one option at a certain option premium.
- If you wish to buy the stock at the end of the contract, that will be the only time where you will pay the total amount of money that is equivalent to the number of option contracts, multiplied by contract multiplier. Refer to #6 for example.
- If the buyer exercises his rights to buy the option (call), the seller (or the writer) is obliged to deliver the underlying asset.
- If the buyer exercises his rights to sell the option (put), the seller is obliged to purchase the underlying asset.
- If the buyer wishes to exercise his rights to either buy or sell the underlying asset, the seller must either sell it or buy it at the strike price, regardless of the its current price.
- In case the buyer of the option decides to do nothing at the end of the contract for whatever reason, the seller keeps the option premium as profit.
- In computing your profit, you have to consider 2 things: the option premium and the strike price. If the option premium is $2 and the strike price is $50, your break-even point is at $52. So in order for you to make a profit, the stock must be more than $52. If the stock falls below $52, say $49, and there is no time left, you won’t lose $3 per stock. What you will lose, however, is the option premium you have paid for the contract.
Note: The numbers were just picked out of the air to illustrate how options trading work. In real world, numbers vary widely so you have to carefully study each of them.
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