Options are one of the most successful investment options available today. They have been proven to be highly flexible and prudent tools for an investor in the stock market. Let’s try to better understand options trading.
What are Options?
Options are contracts that allow you to be involved in trading without buying shares directly. An option contract typically consists of 100 shares. You could buy the contract at the strike price, the agreed-upon price of the shares at the time the contract was executed, for a premium, which lasts for a specified period of time.
Types of Options
There are two types of option contracts. Call options give you the right (not the obligation) to buy the shares at the strike price for a specific time period. Put options, on the other hand, give you the right (not the obligation) to sell the shares at the strike price for the defined period of time.
How to Trade Options
Let’s try to understand options trading with this simple example:
XYZ company is trading at $10 per share. You buy a call options contract of 100 shares with a premium of $2 per share for $200. If the price of the share rises to $20, you could make a profit of $800 on this deal after deducting the cost of the contract i.e. $200.
Contrary to this, you could make a profit from a put option by selling the shares at the strike price when the share price goes down.
Benefits of Options Trading
There are a few benefits to options trading.
Options contract could be used for hedging purposes for your trading portfolio. Hedging with options reduces your risk at a reasonable cost.
Consider this example. XYZ company is trading at $20 per share. You buy a call option contract (100 shares) with a premium of $2 per share for $200. Suppose the share value rises to $30 (an increase of $10), the value of the contract also rises to $1,000.
If you buy 100 shares at $2,000 and sell it for $3,000, you make a profit of $800 after deducting the contract price. So, you have a 140 percent return. But if you sell your contract at its new value of $1,000, your profit will be 800, a return of 400 percent on your investment of $200.
Options Contract are Flexible
You could enforce your American options at any time during the tenure of the contract. This strategy gives you a lot of flexibility to use options for your advantage.
Risks Associated with Options Trading
As with other kinds of investments, there are a few risks involved with options trading.
Time may not be Favorable
All options contracts have a set tenure and expire on a certain date. The value of the premium deteriorates at a fast rate as the expiration date gets closer. Eventually, the options could become worthless, and you could lose the total amount that you paid for the contract.
Options Price may Move Very Fast
You need to wisely invest in options as the price of options moves very fast due to its high profitability.