An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a predefined price, referred to as the strike price, prior to the expiration date. It may sound similar to a futures contract, yet, traders that buy options contract are not obligated to settle their position.
There are two types of options, known as calls and puts, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income. Generally, call options allow contract owners to buy the underlying asset, while put options confer the right to sell. As such, traders usually opt into calls when they expect the price of the underlying asset to increase, and puts when they expect the price to decrease. They may also use calls and puts hoping for prices to remain stable ― or even a combination of the two types ― to bet in favour or against market volatility.
How Does Options Contract Work?
- Options give you the right to buy or sell an underlying instrument.
- If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to.
- If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset.
- Options are good for a specified period of time, after which they expire, and you lose your right to buy or sell the underlying instrument at the specified price.
- When bought, options are done so at debit to the buyer.
- When sold, options are done so by giving a credit to the seller.
- Options are available in several strike prices representing the price of the underlying instrument.
- The cost of an option is referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.
- Options are not available on every stock. There are approximately 2,200 stocks with tradable options. Each stock option represents 100 shares of a company’s stock.
Why Does An Options Contract Matter?
An options contract is an important tool that gives traders the opportunity to hedge their stock positions. Options allow a leveraged position on stock while mitigating the risk of the full purchase. Similarly, in real estate, an options contract may permit a buyer to secure options contracts on multiple parcels before having to execute the purchase on any single one, ensuring that the buyer will be able to assemble them all before moving ahead.
The Advantages and Disadvantages of Options Contract
Options contracts are significant investment vehicle; therefore, it is vital to learn and know the unique characteristics of options before you decide to trade them.
- Leverage. Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
- Risk/Reward Ratio. Some strategies, like buying options, allows you to have unlimited upside with limited downside.
- Unique Strategies. Options allow you to create unique strategies to take advantage of different characteristics of the market – like volatility and time decay.
- Low Capital Requirements. Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much with $1,000 in the stock market.
- Lower liquidity. Many individual stock options don’t have much volume at all. The fact that each optionable stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes. This lower liquidity won’t matter much to a small trader that is trading just 10 contracts though.
- Higher Spreads. Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs when doing an options trade because you will be giving up the spread when you trade.
- Higher Commissions. Options trades will cost you more in commission per dollar invested. These commissions may be even higher for spreads where you need to pay commissions for both sides of the spread.
- Complicated. Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don’t.
- Time Decay. When buying options, you lose the time value of the options as you hold them. There are no exceptions to this rule.
- Less Information. Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
- Options Not Available for All Stocks. Although options are available on a good number of stocks, this still limits the number of possibilities available to you.
Our Two ‘Sats’
It is worth noting that options trading, as well as other derivatives, involves many risks. Before making use of this type of contract, traders should have a good knowledge of how it works. It is also important to have a good understanding of the different combinations of calls and puts and the potential risks involved in each strategy. Also, traders should consider employing risk management strategies along with technical and fundamental analysis to limit the potential losses.
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