How do options work?
Like stocks, when you want to convert upward or downward movements in the market into capital, options can give you a trading position in the market. However, unlike stocks, for a certain trading position, whether it is in an individual stock or in a group of stocks that reflect the overall market, investors can borrow options to hold leverage on it. At the same time, the buyer of an option can enjoy the advantages of a predetermined, limited risk. On the contrary, if they do not use hedging to cover their positions, the seller of the option has to bear substantial risks.
An option is the right to buy or sell a certain stock (or other securities) at a certain price before a certain date, but it is not such an obligation. A call option is the right to buy the stock; a put option is the right to sell the stock. The purchaser of an option, whether it is a call option or a put option, is the “buyer” of the option; on the contrary, the initial selling of the call or put option is the “seller” of the option.
An option is a type of contract in which the conditions of the contract are standardized. It gives the buyer the right but not the obligation to buy or sell an asset (for example, its underlying stock) at a fixed price (fixed price) within a specific period (until the contract expires). For the buyer, a call option on common stock usually represents the right to buy one hundred shares of the underlying stock, and a put option on common stock usually represents the right to sell one hundred shares of the underlying stock. If the buyer of the option performs the contract, the seller of the option must take corresponding actions in accordance with the conditions specified in the option contract: for the seller of the call option, it is to sell the stock at the price specified in the contract (contract price); for the seller of the put option In other words, it is to buy the stock at the price stipulated in the contract (contract price). All options traded on American stock exchanges are issued, guaranteed and cleared by Options Clearing Corporation (OCC). OCC is a clearing company registered with the Securities and Exchange Commission (SEC) and has a reputation of “AAA” in the credit rating of Standard & Poor’s Corporation. The credit rating of “AAA” is equivalent to saying that the option clearing company is capable of assuming the obligations of the counterparty in the option transaction.
The price of an option is called the “premium” (premium). Regardless of the performance of the underlying stock, the loss of the option buyer will not be greater than the premium paid initially for the contract. This makes it possible for investors to quantitatively control the risks they assume. In contrast, the seller of the option receives the buyer’s premium in exchange for the risk of accepting the transfer once the contract is fulfilled.
Consistent with the standardized conditions of the contract, all options are invalidated on a certain date, which is called the “expiration date” (expiration date). For traditional listed options, this can be within nine months from the first day of listing of the option. In addition, there is also a long-term option contract with a contract expiration date that can last up to three years from the time the option is listed for trading, called LEAPS (Long-term Common Stock Expected Securities). American-style options (the most traded) and European-style options have different regulations on contract expiration and option exercise. American options can be exercised at any time between the date of purchase and the expiry date of the contract. In contrast, European options (mainly cash-settled options) can only be exercised on a specific date immediately before the expiry date of the contract.
How to use options
If you foresee that the price of a stock will move in a certain direction, then this right to buy and sell such stocks at a predetermined price for a certain period of time can provide you with an attractive investment opportunity. Which type of option you buy depends on whether your view of the stock trend is positive (long) or negative (short). If your view of the stock’s trend is positive, buying a call option will create an opportunity to share potential stock market gains when the risk is only a small part of the stock market value. In contrast, if you foresee a downtrend, buying put options allows you to protect the stock market from falling risks without limiting the possibility of profit. Purchasing options allows you to seek a certain trading position based on your expectations of the market, gaining benefits, limiting risks, and protecting yourself.
Basic Option Trading Method
We know that options can be divided into two types: call options and put options, and option traders can also buy or sell options. Therefore, there are four basic strategies for option trading: buy call options and sell options. Call options, buy put options, and sell put options.
- Buy call options
If a trader buys a call option, and then the market price really rises and rises above the strike price, the trader can execute the option and make a profit. Theoretically, the price can rise indefinitely, so the profit of buying a call option is theoretically infinite. If the expiration has not risen above the strike price, the trader can abandon the option, and the maximum loss is the option premium.
- Buy put options
If a trader buys a put option, and then the market price drops below the strike price, the trader can execute the option to make a profit. Since the price cannot fall to a negative number, the maximum profit of buying a put option is the exercise The difference between the price and the premium. If the expiration continues to rise above the strike price, the trader can abandon the option, and the maximum loss is the option premium.
- Sell call options
If a trader sells a call option and fails to rise above the strike price before the expiry date, the buyer of the call option will abandon the option, and the seller of the call option will receive the option premium income. Conversely, the buyer of a call option will require the option to be exercised, and the seller of the option will lose the market price minus the difference between the exercise price and the premium.
Here, it should be noted that as an option seller, the maximum profit is the option premium; the value of the profit range is negative.
- Sell put options
If a trader sells a put option and fails to fall below the strike price before the expiration date, the buyer of the put option will abandon the option, and the seller of the put option will receive premium income. Conversely, the buyer of the put option will demand the exercise of the option, and the seller of the option will lose the strike price minus the difference between the market price and the premium.