How options trade

If a trade is made with more than one contract, then the tick value is increased accordingly. Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell.

Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date European options , or at any time up until the expiration date American options. Like futures markets , options markets can be traded in both directions up or down.

If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case, the trader does not care which direction the market moves. With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down.

The following chart may help explain this further:. Basic options trades can be either long or short and can have two different risks to reward ratios. The risk to reward ratios for long and short options trades are as follows:. Long Trade. Short Trade. As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk. However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades and actually have less risk than buy and hold stock trades.

When a trader buys an options contract either a Call or a Put , they have the rights given by the contract, and for these rights, they pay an upfront fee to the trader selling the options contract. This fee is called the options premium, which varies from one options market to another, and also within the same options market depending upon when the premium is calculated. The option's premium is calculated using three main criteria, which are as follows:. A long options trade is entered by buying an options contract and paying the premium to the options seller.

If the market then moves in the desired direction, the options contract will come into profit in the money. There are two different ways that an in the money option can be turned into realized profit. The first is to sell the contract as with futures contracts and keep the difference between the buying and selling prices as the profit. Selling an options contract to exit a long trade is safe because the sale is of an already owned contract. The second way to exit a trade is to exercise the option and take delivery of the underlying futures contract, which can then be sold to realize the profit.

This is the preferred strategy for traders who:. Options are leveraged instruments, i.

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A standard option contract on a stock controls shares of the underlying security. Because the option contract controls shares, the trader is effectively making a deal on shares. Potential profit is unlimited, as the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

A put option works the exact opposite way a call option does, with the put option gaining value as the price of the underlying decreases. While short-selling also allows a trader to profit from falling prices, the risk with a short position is unlimited, as there is theoretically no limit on how high a price can rise. With a put option, if the underlying rises past the option's strike price, the option will simply expire worthlessly.

The maximum profit from the position is capped since the underlying price cannot drop below zero, but as with a long call option, the put option leverages the trader's return. This is the preferred position for traders who:. A covered call strategy involves buying shares of the underlying asset and selling a call option against those shares. When the trader sells the call, he or she collects the option's premium, thus lowering the cost basis on the shares and providing some downside protection. In return, by selling the option, the trader is agreeing to sell shares of the underlying at the option's strike price, thereby capping the trader's upside potential.

In exchange for this risk, a covered call strategy provides limited downside protection in the form of premium received when selling the call option. A protective put is a long put, like the strategy we discussed above; however, the goal, as the name implies, is downside protection versus attempting to profit from a downside move. If a trader owns shares that he or she is bullish on in the long run but wants to protect against a decline in the short run, they may purchase a protective put.

If the price of the underlying increases and is above the put's strike price at maturity , the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price. Hence, the position can effectively be thought of as an insurance strategy. The trader can set the strike price below the current price to reduce premium payment at the expense of decreasing downside protection.

This can be thought of as deductible insurance. The following put options are available:. The table shows that the cost of protection increases with the level thereof. If, however, the price of the underlying drops, the loss in capital will be offset by an increase in the option's price and is limited to the difference between the initial stock price and strike price plus the premium paid for the option.

These strategies may be a little more complex than simply buying calls or puts, but they are designed to help you better manage the risk of options trading:.

The basics of options

Options offer alternative strategies for investors to profit from trading underlying securities. There's a variety of strategies involving different combinations of options, underlying assets, and other derivatives. Basic strategies for beginners include buying calls, buying puts, selling covered calls and buying protective puts. There are advantages to trading options rather than underlying assets, such as downside protection and leveraged returns, but there are also disadvantages like the requirement for upfront premium payment. The first step to trading options is to choose a broker.

Fortunately, Investopedia has created a list of the best online brokers for options trading to make getting started easier. Chicago Board Options Exchange. Your Privacy Rights.

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