The first—and perhaps biggest—challenge of options trading is understanding what an option is.
An option is a contract giving you the right, but not the obligation, to buy or sell a specific security at a specific price over a specific period of time. After that period of time has elapsed (known as “expiration day”), the option ceases to exist.
A call option gives you the right to buy the security.
A put option gives you the right to sell the security.
There are numerous types of options trades. Depending on which method you choose, options trading can be used to hedge a portfolio, create yield or gain significant market exposure and returns with little capital risk.
Options contracts typically represent 100 shares of the underlying stock. So, if you exercise a call, you’re buying 100 shares of the underlying stock; if you exercise a put, you are selling the underlying at a stated price—known as the “strike price.”
Other terms to remember that can help you understand options trading:
Options Premium: This is also known as the options “price.” The potential loss for the holder of an option is limited to the premium paid for the contract. On the other hand, the initial premium can offset the potential loss for the seller of the option.
Time Decay: All options are wasting assets whose time value erodes by expiration—and that erosion is called “time decay.” The more time remaining until expiration day, the higher the premium will be. That’s because the longer an option’s lifetime, the greater the possibility that the underlying share price will move to make the option in-the-money.
Implied Volatility: If the market becomes volatile, or if volatility is expected, implied volatility will rise, thereby increasing options prices. Conversely, low market volatility lowers options prices. The VIX – a.k.a. the investor “fear gauge”—is the best way to measure near-term volatility in the S&P 500. It represents the market’s volatility expectations over the next 30 days.
Still confused? Let our options trading expert Jacob Mintz explain more about options basics, and his own personal options strategies. Jacob runs two options services for Cabot Investing Advice: Cabot Options Trader, catered to options trading beginners, and Cabot Options Trader Pro, for more experienced options traders.
Jacob carefully assesses the risk and reward of each one of his options trades. When he buys options, he risks pennies to make dollars. When he sells options, he does so with very defined risk to avoid big losses. Sometimes Jacob uses conservative options strategies to hit singles; other times he uses more aggressive strategies to try to hit home runs.
There is great mystery that surrounds options trading. Some investors avoid it altogether because they think it’s too confusing or too risky. But it’s easier to comprehend than you think. And once you get the hang of options trading, the risks can be easily minimized.
If done right, options trading can be simple and – more importantly – lucrative.
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