Options are financial contracts that give the holder the right to buy or sell a financial instrument at a specific price for a certain period of time. Options are available for numerous financial products, such as stocks, funds, commodities, and indexes. Like most other asset classes, options can be purchased with brokerage investment accounts.

Options trading may seem overwhelming at🦹 first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.

There are three key features of options:

• Strike price: This is the price at which an option can be exercised.
• Expiration date: This is the date at which an option expires and becomes worthless.
• Option premium: This is the price at which an option is purchased.

Why Trade Options?

Options are powerful because they can enhance an individual’s 澳洲幸运5开奖号码历史查询:portfolio, adding income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal.

Options can be used as a hedge against a declining stock market to limit downside losses. In fact, options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Just as you insure your house or car, options can be 𝓀used to insure your investments against a downturn.

Imagine that you want to buy technology stocks, but you also want to limit losses. By using put options, you could limit your downside risk and cost-effectively enjoy all the upside. For 澳洲幸运5开奖号码历史查询:short sellers, call options can be used to limit losses if the underlying price moves against their trade—especially during a 澳洲幸运5开奖号码历史查询:short squeeze.

Options can also be used for speculation. 澳洲幸运5开奖号码历史查询:Speculation is a wager on future price direction. A speculator mighꦯt think the price of a stock will go up, perhaps based on fundamental analysis or technical 🔜analysis.

A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders because options provide leverage. An out-of-the-mo🔯ney call option may only cost a few dollars or even cents compared with the full price of a $100 stock.

How to Trade Options

Many brokers today allow access to options trading for qualified customers. If you want access to options trading, you will have to be approved for both margin and options with your broker.

Once approved, there are four basic things you ca☂n do with 🦋options:

1. Buy (long) calls
2. Sell (short) calls
3. Buy (long) puts
4. Sell (short) puts

Buying stock gives you a long position. Buying a call option gives you a potential long position🌜 in t🦄he underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.

Buying a put option gives you a potential short position ♉in the underlying stock. Selling a naked or unmarried put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.

People who buy options are called holders, and those who sell options are called writers of options. Here is the important distinction between hold🌞er♓s and writers:

1. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
2. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in the money. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more—and in some cases, unlimited—risks. This means writers can lose much more than the price of the options premium.

Options can also gene🐼rate recurring income. Additionally, they are often used for ♋speculative purposes, such as wagering on the direction of a stock.

Note that options trading usually involves trading commissions—often, a flat per-trade fee plus a smaller amount per contract—for instance, $4.95 + $0.50 per contract.

How Do Options Work?

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option that profits from that event would be. For instance, a call value goes up as the stock (澳洲幸运5开奖号码历史查询:underlying) gജoes up. T💝his is the key to understanding the relative value of options.

The less time there is until expiry, the less value an option wiཧll have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day.

Because time is a component of 澳洲幸运5开奖号码历史查询:the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice🥃 versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is known as 澳洲幸运5开奖号码历史查询:time decayꩵ. The same option will be worth less tomorrow🔴 than it is today if the price of the stock doesn’t move.

Vo💫latility also increases the pri🌱ce of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibility of substantial moves both up and down.

Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. ♋Options trading andꦑ volatility are intrinsically linked to each other in this way.

On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.

The majority of the time, holders🌞 choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close.

According to the Cboe, over the long term, more than seven in 10 option contracts are closed out before expiring, about another two in 10 expire without value, and about one in 20 get exercised.

Fluctuations in option prices can be explained by 澳洲幸运5开奖号码历史查询:intrinsic value and 澳洲幸运5开奖号码历史查询:extrinsic value, wh🐭ich is also known as time value. An option’s premium is the combinati❀on of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading.

Time value represents the added value an investor has to pay for an option above the intrinsic val🌃ue. This is the extrinsic value or time value. So the price of the option in our example can be thought of as the following:

In real life, options almost always trade at some level above their ᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚintrinsic value, because the probability of an event occurring is never abso🌱lutely zero, even if it is highly unlikely.

Types of Options: Calls and Puts

Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an 澳洲幸运5开奖号码历史查询:options contract, it grants you th✱e right but not the obligation to buy or sell an underlying asset at a set price on or before ൩a certain date.

A 澳洲幸运5开奖号码历史查询:call option gives the holder the right to buy a stock, and a 澳洲幸运5开奖号码历史查询:put option gives the holder the right to sell a stock. Think of﷽ a call option as a down payment on a future purchase.

Call Options

A call option gives the holder the right, but not the obligation, to buy the under🐭lying security at the strike price on or before expiration. A call option will therefore become more valuable as the u⛎nderlying security rises in price (calls have a positive delta).

A long call can be used to speculate on the price of the underlying rising since it has u🎀nlimited upside potential, but the maximum loss is the premium (price) paid for the option.

Call Option Example

A potential homeowner sees a🍨 new development going up. That person may want the right to purchase a home in the future but will only want to exercise that right after certain developments around the area are built.

The potential homebuyer would benefit from the option of buying or not. Im🍷agine they can buy a call option from the developer to buy the home at, say, $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit.

Naturally, the developer wouldn’t grant such an option🦩 for free. The potential homebuyer needs to contribute a down payment to lock in tha🌜t right.

With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, theไ deposit might be $20,000 that the buyer pays the developer.

Let’s say two years have passed, and𓃲 now the developments are built and zoning has been approved. The ဣhomebuyer exercises the option and buys the home for $400,000 because that is the contract purchased.

The market value of that home may have doubleꦰd to $800,000. But because the down payment locked in a predetermined price, the bu🔜yer pays $400,000.

Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the homeb🌺uyer must pay ♑the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.

Put Options

Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the undeꦐrlying stock at the strike price on or before expiration.

A long put, therefore, is a short position in the underlying security, since the put gains value as the underlying price falls (they have a negative delta). 澳洲幸运5开奖号码历史查询:Protective puts can be purchased as a sort of insurance, providing a price floor🐓 for investors to hedge their positions.

Put Option Example

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with the pro꧃cess of purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage.

They pay an amount called a premium for a certain amount of time—let’s say a year. The po♊licy has a face value and gives the insurance holder protection in the event the home is damaged.

What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on their S&P 500 🦄index portfolio, they can purchase put options.

An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long ♑position in the S&P 500 index. If the S&P 500 is currently trading at $2,500, they can purchase a put option giving them the right to sell the index at $2,250, for exa✅mple, at any point in the next two years.

If in six month🗹s the market crashes by 20% (500 points on the index), they have made 250 points by being able to sell the index🍬 at $2,250 when it is trading at $2,000—a combined loss of just 10%.

In fact, even if the market drops t🦩o zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.

Uses of Call and Put Options

Call options and put options are used in a variety of situations. The table below outlines some use cases for call and put options.

Examples of Trading Options

🐷Call options and put options can only function as effective hedges when they limit losses and maximize gains. Suppose y🅠ou’ve purchased 100 shares of Company XYZ’s stock, betting that its price will increase to $20.

Therefore, your total investment is $1,000. To hedge against the risk that the price might decline, you purchase one put option (each options contract r𝓀epresents 100 shares of the underlying stock) with a strike price of 10, each worth $2 (for a total of $200).𒊎

Consider the situation when the stock’s price goes your w⛦ay (i.e., it increases to $20). In such a scenario, your put options expire worthless. But your losses are limited to the premium paid (in this case, $200🌺).

If the price declines (as you bet it would in your put options), then your maximum ga❀ins are also capped. This is because the stock price cannot fall below zero, and therefore, you cannot make more money than the amount you ma🍷ke after the stock’s price falls to zero.

Now, consider a situation in which you’ve bet that XYZ’s stock price will decline to $5. To hedge against this position, you’ve purchased call stock opti𝐆ons, betting that the stock’s price will increase to $20.

What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s price after it takes off. Theoretically, XYZ can 🍰go all the way to $100,000 or higher. Therefore, your gains are not capped and are unlimited.

The table below summarizes gains a♌nd losses for options buyers.

Using Long Calls

As the name indicates, going long on a call involves buying call o🅺ptions, betting that the price of the underlying asset will increase with time.

For example, suppose a trader purchases a contract with 100 call options for a stock that’s currently trading at $10. Each option is priced at $2. Therefore, the total investment in the contract 𝐆is $200. The trader will recoup her costs when the stock’s price reaches $12.

Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, a꧅nd it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2.

Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its pri♒ce goes down instead of up), then the options expire worthless and the trader loses only $200.♐ Long calls are useful strategies for investors when they are reasonably certain that a given stock’s price will increase.

Writing Covered Calls

In a short call, the trader is on the oppo𓆉site side of ওthe trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame.

But 澳洲幸运5开奖号码历史查询:writing a naked call—wit𒊎hout owning actual stock—can also mean unlimited losses for the trader because, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.

A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a covered call limits losses a🔯nd♈ gains because the maximum profit is limited to the amount of premiums collected.

Covered calls writers can buy back the options when they are close to in the money. Ex🧔perienced traders use covered calls to generate income from thei𝓰r stock holdings and balance out tax gains made from other trades.

Long Puts

A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a trader purchases a one 10-str🌸ike put option (representing the right to ꧋sell 100 shares at $10) for a stock trading at $20.

Each option is priced at a premium of $2. Therefore, the total𝐆 investment in the contract is $200⛦. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike - $2 premium).

Thereafter, the stock’s losses mean profits for the trader. But these profits are capped bওecause the stock’s price cannot fall below zero. The losses are also capped because the tr꧋ader can let the options expire worthless if prices move in the opposite direction.

Therefore, the maximum losses that the trader will experience are limited to the premium amounts paid. Long puts are usef𓃲ul for investors when they are reasonably certain that a stock’s price will move in their desired direction.

Short Puts

In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. How๊ever, the max🐠imum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise their option.

Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money an✅d generates income through the premium collected.ꦰ

Combinations

The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to the 🍷loss of the option premium spent.

If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle. This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose the premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sur✅e in which direction.

Basically, you need the stock to move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price m⛦oves in either direction to profit but is also less expensive than a straddle.

On the other hand, being 澳洲幸运5开奖号码历史查询:short a straddle or a strangle (selling both options) would profit from a market that doesn’t move much🐠.

Spreads

Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads♌ often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared with a single options leg. There are many types of spr𝔉eads and variations on each. Here, we just discuss some of the basics.

澳洲幸运5开奖号码历史查询:Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike. A bull call spread, or澳洲幸运5开奖号码历史查询: bull call vertical spread, is created by buying a call and simultaneously selling another call with a hi♚gher strike price and the same expiration.

The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short-call strike. The benefit, however, is that 🐷selling the higher strike cജall reduces the cost of buying the lower one.

Similarly, a 澳洲幸运5开奖号码历史查询:bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a 澳洲幸运5开奖号码历史查询:calendar spread or time spread.

A 澳洲幸运5开奖号码历史查询:butterfly spread consists of options at three strikes, equally spaced apart, wherein all options are of the 🙈same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bღought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor—the difference ౠis that the middle options are not at the same strike price.

Synthetics

Combinations are trades constructed with both a call and a put. There is a special type of combination known as a 澳洲幸运5开奖号码历史查询:synthetic. The point of a synthetic is to cr꧂eate an options position that behaves like an underlying asset but witho༺ut actually controlling the asset.

Why not just buy the stock? Maybe some legal or regulatory reason ᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚrestricts you from owning it. But you may be allowed to create a synthetic position using options. For instance, if you buy an equal amount of calls as you sell puts at the same strike and expiration, you have created a synthetic long position in the underlying.

Boxes are another example of using options in this way to create a synthetic loan, an options spread that effectively behaves like a zero-coupon bond until it expires.

The Bottom Line

Options do not have to be difficult to understand when you grasp their 澳洲幸运5开奖号码历史查询:basic concepts. Options can 澳洲幸运5开奖号码历史查询:provide opportunities when used correctly and can be harmful when used incorrectly. If you’re new to the options world, take your time to understand the intricacies and practice 💃before putting down serious money.

Correction—Oct. 24, 2024: This article has been corrected to state that writing a naked call—without owning actual stock—could lead to unlim▨ited losses for a༺ trader.