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Options Trading - The 10-Step Guide

What are options?


To start with, options are a form of derivative in the markets. Derivatives are a group of investments that derive their value from an underlying security. Think of it as a bet between whether that underlying security is going to go up or down.


Stock options are not that different from this analogy.



An option is a security sold from one investor to another with an agreement (in the form of a contract) between the two parties.


The buyer of the options contract pays a premium to the option writer/option seller. In exchange, the buyer will be given the right to buy a specific investment from or to the other party at a pre-determined price at some point in the future.


The right to buy the share from the option seller is known as a call, and the option to sell a share is called a put. We’ll get into this later don’t worry.



Did you know that one of the reasons why GameStop ($GME) went on an insane short squeeze is because of options? Well, today, you’ll be learning all about options trading for dummies and everything around it.




Key takeaways:


 

Terminology


Premium – The price of the option contract.


Strike price – The pre-agreed price at which the stock can be bought or sold depending on the terms of the contract. Commonly referred to as the “exercise price”.


ITM (In the money) – When the stock price is above the strike price of a certain options contract.


OTM (Out of the money) – When the stock price is below the strike price of a certain options contract.


Intrinsic value – The value of an option at expiration.


Extrinsic value – The value of an option at expiration plus the external factors of time value and implied volatility.



Buying call options





You buy a call option when you expect the stock price to increase. When you buy a call option, otherwise known as calls, you will be paying the option premium (price of the option) for the right to buy the shares of the underlying asset at a fixed price (strike price) on or before the expiration date of the contract.




Some traders prefer to buy calls instead of the asset itself because of the leverage it provides.


It can be an effective way to of increasing their exposure without tying up a lot of their funds.




However, there is also a higher possibility that traders can lose 100% of their position as the option expires worthless. Institutions, large investors, and funds often use calls to control large amounts of shares with relatively small capital or to hedge their position.


Buying put options


While a call option gives you the ability to purchase shares of a stock at the call’s strike price, a put option (puts) gives you the ability to sell shares at the puts’ strike price.


In simple terms, a call option will become more valuable when the stock price increase and a put option becomes more valuable when the stock price decreases.


Similar to call options, the value of put options will also fluctuate based on the stock’s price changes. Again, traders and investors buy put options as opposed to shorting the shares of a stock because it gives them much more leverage without risking too much.



A huge difference between this is that when you buy a put option, your potential loss is only 100%, assuming your option expires worthless. However, if you’re shorting a stock, your potential loss is actually infinite, because theoretically, there is no ceiling to how high the price of a stock can actually increase.


Selling call options


Selling options is a different concept altogether, but the fundamentals of it are that the call option seller will make money if the price of the stock remains under the strike price. For the best-case scenario, it would mean that the option expired worthless and the option seller/writer has realized their maximum profit (100%).