Learn How To Trade Options For Beginners – Options are a form of derivative contract that gives contract buyers (option holders) the right (but not the obligation) to buy or sell a security at a selected price at some point in the future. For such a right, sellers charge option buyers a sum called a premium. If market prices are unfavorable for option holders, they will allow the option to expire worthless and will not exercise this right, ensuring that any loss does not exceed the premium. On the other hand, if the market moves in the direction that that right is greater, exercise it.
The underlying asset at a predetermined price in the future, called the strike price or strike price. With a put option, the buyer acquires the right
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Let’s look at some basic strategies that a novice investor can use with calls or bets to limit their risk. The first two involve using a directional bet option with a limited downside if the bet is wrong. Others include hedging strategies placed on top of existing positions.
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Options trading has some advantages for those who want to make directional bets on the market. If you think the price of the asset will rise, you can buy a call option with less capital than the asset itself. If the price instead falls, your losses are limited to the premium you paid for the options and no more. This may be a preferred strategy for traders who:
Options are essentially instruments of leverage because they allow traders to maximize potential upside by using smaller amounts than would otherwise be required to trade the underlying asset itself. So instead of buying $10,000 worth of 100 shares at $100, you could hypothetically spend, say, $2,000 on a call contract that has a 10% premium to the current market price.
Let’s say a trader wants to invest $5,000 in Apple (AAPL), which trades for about $165 per share. With this money, they can buy 30 shares for $4,950. So let’s say the stock price rises 10% over the next month to $181.50. Excluding brokerage or transaction fees, the trader’s portfolio would grow to $5,445, giving the trader a net return of $495 or 10% of invested capital.
Now, suppose a call option with a strike price of $165 on a stock that expires in about a month is worth $5.50 per share, or $550 per contract. Based on the trader’s available investment budget, he can buy nine options at a price of $4,950. Since the option contract controls 100 shares, the trader is effectively trading 900 shares. If the stock price rises 10% to $181.50 at expiration, the option will expire in-the-money (ITM) and be worth $16.50 per share ($181.50 to $165) or $14,850 for 900 shares. That’s a net return of $9,990 or 200% on invested capital, a much higher return compared to trading directly on the underlying.
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A seller’s potential loss from a long call is limited to the premium paid. The potential profit is unlimited because the option payout will increase with the underlying price until expiration, and there is theoretically no limit to how high it can go.
While a call option gives the holder the right to buy the underlying instrument at a specified price before the contract expires, a put option gives the holder the right to:
A put option effectively works in the exact opposite direction to a call option, with a put option gaining value as the price of the underlying instrument falls. While short selling also allows the seller to profit from falling prices, the risk in a short position is unlimited because there is theoretically no limit to how high the price can go. If the underlying value of the put option is higher than the strike price of the option, the option will simply be worthless.
Let’s say you think the stock price is likely to fall from $60 to $50 or lower due to earnings, but you don’t want to take the risk of selling the stock short if you’re wrong. Instead, you can buy $50 for a $2.00 premium. If the stock does not go below $50, or if it actually goes up, you will lose no more than $2.00 in premium.
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However, if you are right and the stock goes to $45, you will make $3 ($50 minus $45 minus the $2 premium).
In a long sale, the potential loss is limited to the premium paid for the options. The maximum profit from the position is limited because the underlying price cannot fall below zero, but like a long call option, a put option takes advantage of the seller’s return.
Unlike a long call or long put, a covered call is a strategy that matches an existing long position in the underlying asset. It is essentially a bid to sell at an amount that covers the size of the existing position. In this way, the writer of the covered calls collects the option premium as income while limiting the upside potential of the underlying position. This is a preferred position for traders who:
A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option premium is collected, which reduces the basis of the stock’s value and provides some downside protection. Instead, by selling an option, the trader agrees to sell shares of the underlying instrument at the option’s strike price, thereby limiting the seller’s upside potential.
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Suppose a trader buys 1,000 shares of BP (BP) at $44 per share and simultaneously enters into 10 call options (one contract for every 100 shares) with a strike price of $46, expiring in one month, at $0.25 per share, or At a price of $25. contract and a total of $250 for 10 contracts. The $0.25 premium reduces the basis of the stock to $43.75, so any decline in basis up to that point will be offset by the premium from the option position, which offers limited protection.
If the stock price rises above $46 before expiration, the short call option will be exercised (or “called”), meaning the seller must deliver the stock at the option’s strike price. In this case, the trader would make a profit of $2.25 per share ($46 strike price based on a cost price of $43.75).
However, this pattern suggests that the trader does not expect BP to break above $46 or significantly below $44 in the next month. As long as the stock does not rise above $46 and is called before the option expires, the trader will keep the premium free and clear and can continue to trade the stock for the stock if desired.
If the stock price rises above the strike price before expiration, the short call option can be exercised and the seller must deliver the stock at the strike price of the option, even if it is lower than the market price. Against this risk, a covered call strategy provides limited downside protection in the form of the premium received when selling a call option.
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A defensive put price involves buying a negative put price to the extent that it covers an existing position in the underlying asset. In effect, this strategy sets a floor below which you can no longer lose. Of course, you will have to pay an option premium. Thus, it acts as a kind of insurance against losses. This is the preferred strategy for traders who own the underlying asset and want to hedge against the downside.
Thus, a protective position is a long position, just like the strategy discussed above; However, the goal, as the name suggests, is to protect against declines versus trying to profit from decline moves. If a trader owns a stock that is rising in the long term, but wants to protect himself from a short-term decline, he can buy a defensive stock.
If the price of the underlying rises above the strike price at expiration, the option expires worthless and the trader loses the premium but still benefits from the increased strike price. On the other hand, if the underlying price falls, the trader’s position in the portfolio loses value, but that loss is largely covered by the profit from the put option position. Therefore, the position can actually be considered as an insurance strategy.
A trader can set the strike price below the current price to reduce the premium payment at the expense of downside protection. This can be understood as deductible insurance. Let’s say an investor buys 1,000 shares of Coca-Cola ( KO ) at $44 and wants to protect the investment from adverse price movements over the next two months. The following sales options are available:
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The table shows that the cost of protection increases with its level. For example, if a trader wants to protect an investment against any decline in price, he can buy 10 options for the strike
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