April 02, 2021
New investors will hear a flood of unfamiliar terms and financial concepts while they make their first steps into the investment world. Options trading is one of them.
Trading options is not the same as trading stocks. It is important for new, interested investors to develop a fundamental understanding of what options are and why they’re valuable. While novice investors risk losing insurmountable amounts of money on ill-advised trades, learning the basic science behind it all can help the casual investor make strategic decisions.
Options literally give you the option.
Acquiring a stock option gives an investor the right to buy or sell a stock at a predetermined price and date. It is important to mention that options are not stocks and do not commit an investor to purchase or sell it. However, the investor must exercise the option within a certain period of time and before the contract expires, or else they risk a total wash on their investment.
Options include a few different components.
These consists of the contract, the premium, the strike price, and the expiration date. Here’s the meaning of each of these terms.
- The contract is the agreement you buy.
- The premium is the price you pay for the contract.
- The strike price is what you pay for the stock, underlying investment, or the payout you get when you sell.
- The expiration date refers to the predetermined period of time the option is active. Within this time period, it is crucial that investors exercise their options. If you decide to hold an option until after its expiration date, nothing happens and in most cases, the investor will lose money.
What are calls and puts?
The two main types of options investors trade are calls and puts.
Calls give an investor the right to buy a stock.
Puts give an investor the right to sell a stock.
Generally, investors will trade options for two different reasons: hedging and speculation.
What is hedging?
Hedging is another way of saying investment insurance. Asset prices tend to move up and down as naturally as the world continues to evolve and change at a rapid pace. To protect investors from inevitable shifts in the market, they can mitigate their risk by making a hedge, an investment to reduce the risk of adverse price shifts.
Investors will speculate that the price of a stock will be higher in the future, so they buy an option that allows them to purchase the stock ahead of time at a lower price than what it is predicted to be. Then the investor will exercise the option and profit from the price difference.
Trading options can be profitable for those who are well-versed in the markets and have developed a thorough understanding of how they work. If you’re a new investor, it is always advisable to seek the guidance of a professional and consult your financial advisor for any advice.