How To Trade Using Options

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A put (or “put”) option is a contract that gives the option buyer the right, but not the obligation, to sell or short a specified amount at a predetermined price within a specified period of time. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.

Put options are traded on a variety of underlying assets, including stocks, currencies, bonds, commodities, futures and indices. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying security at a specified price by the expiration date of the option contract.

How To Trade Using Options

How To Trade Using Options

A put option becomes more valuable when the price of the underlying stock or security falls. Conversely, a put option loses its value when the price of the underlying security rises. As a result, they are commonly used for hedging purposes or to anticipate a negative price action.

What Is Options Trading?

Investors often use put options as a risk management strategy, known as a protective put, which is used as a form of investment insurance or hedging to ensure that losses on the underlying asset do not exceed a certain amount. In this strategy, the investor buys an option to hedge the downside risk on a security held in the portfolio. If the option is exercised, the investor will sell the stock at the stock’s strike price. If the investor does not own the underlying security and exercises a put option, a short position on the security is created.

Typically, due to the time-lapse effect, the value of a put option decreases as its maturity approaches. Time decay accelerates as an option’s expiration approaches, as there is less time to profit from the trade. While an option loses its time value, the intrinsic value remains. The intrinsic value of an option is equal to the difference between the strike price and the price of the underlying stock. If an option has intrinsic value, it is referred to as in-the-money (ITM).

Intrinsic value of the option = difference between the market price of the underlying security and the strike price of the option (for a put option, IV = strike price

Out-of-the-money (OTM) and at-the-money (ATM) put options have no intrinsic value because there is no benefit to exercising the option. Instead of exercising an out-of-the-money option at an undesirable strike price, investors have the option to short the stock at the current higher market price. However, outside of a bear market, short selling is generally riskier than buying put options.

How Can I Trade Options On The Web Platform?

Time value, or extrinsic value, is reflected in the option premium. If the strike price of the put option is $ 20 and the underlying security is currently trading at $ 19, the option has an intrinsic value of $ 1. But the put option can trade for $ 1.35. The additional $ 0.35 is a time value because the underlying stock price can change before the option expires. Several put options on the same underlying asset can combine to form put spreads.

There are several factors to keep in mind when selling put options. It is important to understand the value and profitability of an options contract when considering a trade, otherwise there is a risk that the stock will fall beyond the profitability point.

Put options and many other types of options are traded through brokers. Some brokers have special features and benefits for options traders. For those interested in options trading, there are many brokers that specialize in options trading. It is important to identify a broker that is suitable for your investment needs.

How To Trade Using Options

The buyer of a put option does not have to hold the option to maturity. When the price of the underlying stock moves, the option premium will reflect recent underlying price movements. An option buyer can sell their option and cut a loss or make a profit, depending on how the option’s price has changed since buying it.

How To Trade Options Using Market Profile? With Real Examples

Likewise, a custom writer can do the same. If the underlying price is higher than the strike price, they can’t do anything. This option can expire at any value and allows you to keep the entire premium. But if the underlying price approaches or falls below the strike price, the option author can buy back the option to avoid a big loss (which will cause him to exit the position). The profit or loss is the difference between the premium received and the premium paid for exiting the position.

Suppose an investor buys a put option on the SPDR S&P 500 ETF (SPY), which trades at $ 445 (January 2022) and expires in one month with an exercise price of $ 425. For this option, they paid a prize of $ 2.80 or $ 280 ($ 2.80 × 100 shares or shares).

If the SPY units drop to $ 415 before expiration, the $ 425 put will be “in the money” and will trade at least $ 10, which is the intrinsic value of the put option (ie $ 425 – $ 415). The exact price of a put depends on several factors, the most important of which is the expiry time. Let’s say $ 425 puts trades at $ 10.50.

Since the put option is now “in the money”, the investor must decide whether (a) to exercise the option, which would give him the right to sell 100 shares of SPY at an exercise price of $ 425; or (b) sell the put option and pocket the profit. Let’s consider two cases: (i) the investor already owns 100 SPY shares; and (ii) the Investor does not hold SPY Units. (The following calculations ignore commission costs, to make things easier).

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Suppose an investor exercises a put option. If the investor already has 100 units of SPY (say it was bought for $ 400) in their portfolio and it was bought to reduce risk (i.e. it is a hedge), the investor’s broker will sell 100 shares of SPY. The strike price is $ 425.

What happens if the investor does not own the SPY shares and the put option is purchased exclusively as a speculative transaction? In this case, exercising the put option would be a short sale of 100 SPY units at the strike price of $ 425. To close the short position, the investor can buy back 100 SPY units at the current market price of $ 415.

Exercising an option, selling and buying back stock (short) seems to be a very complicated endeavor, not to mention the additional costs such as commissions (as there are more transactions) and margin interest (for short selling). But the investor actually has an easy “option” (for lack of a better word): to sell the put option at its current price and make a good profit. Calculation of profit in this case:

How To Trade Using Options

Here is an important point to note. Selling the option, instead of going through the relatively tight exercise of the option, actually translates into a profit of $ 770, which is $ 50 more than the $ 720 obtained by exercising the option. Why the difference? Because the sale of the option also acquires a time value of $ 0.50 per share ($ 0.50 × 100 shares = $ 50). Therefore, very long option positions that have value before maturity are sold rather than exercised.

Call Option Definition

For a put option buyer, the maximum loss on an options position is limited to the premium paid for the put. If the price of the underlying stock falls to zero, the maximum profit will occur on the option position.

Most long option positions that have value before maturity are closed by selling rather than exercising, as exercising an option results in a loss of time value, higher transaction costs and additional margin requirements.

In the previous section, we discussed options from the perspective of a buyer or investor with a long-term position. Now let’s turn our attention to the other side of options trading: the put options seller, or put options writer, who holds the short put position.

Unlike a long put option, a short or drawn option requires the investor to take delivery of the underlying stock or buy the stock at the strike price specified in the option contract.

Put Option Definition

Let’s say an investor is bullish on SPY, which is currently trading at $ 445, and does not believe it will fall below $ 430 in the next month. By writing a put option on SPY with an exercise price of $ 430, the investor can reap a premium of $ 3.45 per share (× 100 shares or $ 345).

If the SPY exceeds the strike price of $ 430 next month, the investor will save the premium ($ 345) because the options will expire out-of-the-money. This is the maximum profit of the trade: $ 345 or premium raised.

Conversely, if the SPY drops below $ 430 before the option expires in a month, the investor is looking to buy.

How To Trade Using Options

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