This also means they can lose their entire investment and greatly magnify their losses, too. That’s because options are often used as a form of leverage, giving traders the ability to buy more stock with less money and greatly magnify their returns. Options trading is a highly speculative exercise. With puts, they can’t sell stock at a value that’s greater than the market price to the writer of the option, and with calls they don’t get to buy shares at a discount. The buyer loses the premium they paid for the option. When options contracts-puts or calls-reach their expiration date out of the money, they become worthless. This leaves the writer in possession of the premium, which is their profit on the trade. Think of it this way: The party buying the contract has the right but not the obligation to follow through with the deal, and if a put or call is out of the money, they don’t exercise the option. What about the option writer? They make money when the options contract is out of the money for the buyer at expiration. Once again, the buyer paid a modest premium for the right to sell stock for a higher price than its currently worth on the market. When a put is in the money, the buyer of the contract can exercise the option, obliging the writer to buy stock at a price that is higher than the current market price of the shares. They’ve paid a small fee-the premium-for the right to buy stock at a discount. So here’s how you make money with options: When a call is in the money, the buyer of the contract has the right to exercise the option and purchase the underlying stock from the writer at a price that’s lower than it is on the stock market. This is when the underlying stock price is the same as the strike price. Put options are unprofitable for the buyer when the stock price exceeds the strike price. For the buyer of an options contract, calls are unprofitable when the strike price is higher than the stock price. Put options are profitable for the buyer when the stock price falls below the strike price. For the buyer of an options contract, calls are profitable when the price of the underlying stock is higher than the strike price. Depending on whether the price of the underlying asset rises above or falls below the strike price, the parties to the contract are said to be in the money for a profitable trade or out of the money for a losing trade. The strike price is key to understanding how options make money. That’s because a longer expiration period provides a greater possibility that the underlying share price might move in the right direction to make the contract buyer a profit. The further out the options contract’s expiration date, the higher the premium will be. Typical options contracts are good for 30, 60 or 90 days, but some can have expiration dates of up to a year. This deadline, or expiration date, is the final moment the options contract may be executed. The contract defines a specific price for the trade, called the strike price, and a deadline for the exchange to take place. Premium, Strike Price and Expiration DateĪll options contracts are sold for a fee called a premium. Puts give the purchaser the right (but not the obligation) to sell stock to the creator of the options contract at a set price in the future. Calls give the purchaser of the option the right (but not the obligation) to buy stock from the writer of the option in the future. The world of options is divided between call options and put options, also known as calls and puts. The party who buys the contract gets the option to execute the contract in the future, but they have no obligation to complete the trade.The party who writes the contract is obliged to buy or sell the underlying stock, if necessary. There are always two parties to an options contract: One party creates the option-traders would say they “write” the contract-while the other side buys the option. To help you understand the basics, we’ll stick to explaining options for stocks.Īn option is a contract to exchange an asset like a share of stock at an agreed-upon price in the future. This underlying asset can be a stock, a commodity, a currency or a bond. Options are a type of derivative, which means they derive their value from an underlying asset. While they may seem obscure or hard to parse at first glance, once you grasp a few basic concepts, understanding options isn’t too challenging. When used carefully, options are a tool that can help you manage risk, generate income and speculate about the future direction of markets.
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