Purchasing an option gives the buyer the right, but not the obligation, to buy or sell a specific amount of an underlying security at a specific price within a specified time period. By comparison, a futures contract requires both the buyer and the seller to perform under the terms of the contract, if an open futures position is not offset before expiration.
The decision whether or not to exercise an option is entirely that of the options buyer.
An option buyer cannot lose more than the amount he or she invested in the options premium. The same cannot be said, however, for the buyer of a futures contract.
An option buyer is never subject to margin calls. This enables the buyer to maintain a market position, despite any adverse moves, without putting up additional funds.
Following are some further options basics:
- Buying an option gives you the right to buy or sell an underlying security.
- As an options buyer, you have the right, but not an obligation, to buy or sell an underlying security at a specified price.
- As an option seller (writer), you have obligations to the options buyer.
- There are two types of options: (we do not consider binary options to be true options. If you want to know more about this very risky instrument we recommend that you visit binaryoptions.co.uk to read more.)
- Calls (call options) – give you the right to buy an underlying security.
- Puts (put options) – give you the right to sell an underlying security.
- Each option corresponds to 100 shares of an underlying security.
- The price of an option depends on several factors:
- The current price of the underlying security;
- The strike price of the option;
- The amount of time remaining until the option expires;
- The volatility of an underlying security.
- Strike Price. The price at which an underlying security can be purchased or sold, if an option is to be exercised.
- Expiration Date. The date on which an option expires. It is the 3rd Friday of the expiration month. Each option has an expiration day. After expiry, you have lost the right to buy or sell the underlying security at the strike price.
- Premium. The price of an option. If an option costs $3 per contract, your total premium is $300 (one contract = 100 shares), plus commission (transaction) costs.
- Please note that options are not available on every stock (i.e., not all stocks are option-able).
Investing in Options
Before you begin investing in options, you must decide how much of your money you can safely put at risk. If you are new to options, we recommend no more than 10% of your portfolio.
- With every passing day, your option loses time value
- The easiest way to profit from options is to be an options buyer. You simply buy calls if you think the index will rise, or puts, if you think the index will fall.
- If the index price rises above the strike price of your call option, or if the index falls below the price of your put option, you win your bet.
- If the index does not move the way you thought it would, you could lose the entire premium you paid for your option.
Never wait for an option to expire, always sell it before the expiry date:
Just as important as selecting the right option and paying the right price is knowing how and when to take profits. Most option buyers lose, not because they buy the wrong option, but because they fail to take profits properly.
- When your option begins to show a profit, you must get ready to act.
- Get ready to sell your position if the index drops by 5%(if you bought a call option), or if it rises by 5% (if you bought a put option).
- If your option is in the money and the index makes a big move in your favor, sell your position and pocket the profit.
- Also take profits if your option is in the money, moves past the strike price and enters its last week before expiration.
Cutting your losses is just as important as taking profits.
- The hardest part is convincing yourself to cut your losses.
- If you do not cut your losses quickly, you will not last as an options player.
- If you own an option that has fallen by 50% or more, sell it and close out your position.
Basically, as an options trader you have to know
- When to buy
- When to sell
- Your likely profit target
- At what predetermined target will you take a loss