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What are Options

Just like a stock or a bond, an option is a security. Options are derivatives, deriving their value from another underlying asset. If you are unaware of what a derivative is, you should take a look at my earlier post on financial derivatives.

 

If you own an option, you basically have the option to buy or sell a block of shares of a specific stock at a specific price, within a specific time frame. Notice how the word specific occurs in the previous sentence 3 times. This shows why options are risky because you have to be right about 3 things. You must choose the right stock, predict the degree of its move, and the time it will take to get there. You must make 3 right choices, otherwise, if you are wrong on just one, you'll lose your money.

 

Still confused? Well, basically when you buy an option, there is a contract with set terms, giving you an option to buy or sell a specific stock, index, or future at a specific price on or before a specific date, but it is not an obligation. You don't actually own the stock, nor do you ever have to buy the stock to profit or lose money on options.

 

Options allow traders to make money fast if they're right, but when the market reverses, they can walk away and owe nothing! There is an expression, your loss is limited to what you paid for an option but note that can also mean you can lose 100%!

 

There are 2 main reasons why investors use options: to speculate and to hedge.

 

Options can be extremely volatile and risky investments. Option trading is not suitable for everyone because of its high risk. You definitely need to have a clear idea of what you are doing and understand all the terminology that is associated with the options market. This is what Warren Buffett has been warning investors about for years: the unregulated and growing use of derivatives.

However, options aren't inherently bad. They also provide a hedge to protect investors from losses in particular stocks.

 

There are 2 types of options: puts and calls.

 

Call Option

Call Option gives you the right to buy an asset at a specific price within a set period of time. You buy call options if you expect the price of the underlying stock to rise before the option expires. If the stock price rises, you would make a profit because you previously bought the stock for less and now you can resell it for more. Call options are similar to having a long position on a stock.

 

Put Option

Put Options gives you the right to sell an asset at a specific price within a set period of time. You buy put options if you expect the price of the underlying stock to decline before the option expires. If the stock price declines, you would make a profit because you can now sell at a higher price. Put options are similar to having a short position on a stock.

There are 4 types of participants in the options market:

 

1) Buyers of puts
2) Sellers of puts
3) Buyers of calls
4) Sellers of calls

Buyers of options are called holders and sellers of options are called writers.

 

It's okay if you don't understand options because it is considered very confusing and is often avoided by beginners to the stock market. But depending on the type of trader that you are, you might enjoy options trading so you can look more into that later.