Options are derivative contracts, which allow option holders to sell or buy an asset at a specific price. The option sellers charge a ‘premium’ from the option buyer. If the market is not favorable for option holders, they allow the option to expire worthlessly. So, the losses are less than the premium amount. Option sellers demand this premium as they assume their risk to be greater than the option buyers’.
Options are categorized into –
- Call option – The option buyer purchases the buying rights of an underlying asset in the future at strike price [predetermined].
- Put option – The option buyer purchases the selling rights of an underlying asset in the future at strike price [predetermined].
Traders new to options can join a trading forum like SteadyOptions to gain better knowledge and learn quickly from effective information shared using questions, answers, and comments.
Beginners need to understand the basic option strategies
Long call or buying call
It is a strategy for traders who are confident of a bullish stock or ETF and want to cash in on the rising markets. Options carry leverage, which allows the trades to escalate their benefits. For example, if a trader has desires to invest $6000 in Reliance that is trading at $175 per share, so the trader bought 34 shares for $5,950. Let’s assume the price increased by 10% [$192.5] in 4 weeks. The trader’s portfolio will increase to $6545. The trader will enjoy a 10% [$545] profit on his invested capital.
Assume, the trader wants to place a call option with a strike price of $175, which expires in 4 weeks from now at the price of $6 per share or $600 per contract [Option contract controls 100 shares]. A trader can buy 10 options for $6000.
It means the trader can effectively buy 900 shares. If rates increase by 10% [192.5] at expiration the option will get expired in-the-money, so it will be worth $17.50 per share. So, the trader will earn 900 shares x $17.50 = $15,750. So, the net dollar earned is $9750 or on the capital invested. It is 200% more than trading underlying instruments directly.
Long put or buying puts
When a specific stock or index or ETF is bearish the trader will go long put to exploit the falling prices. The put option is opposite to the call option. In the put option, the underlying instrument’s value decreases. Going short allows a trader to earn from the declining prices.
Covered call
When no changes or a little increase is expected at an underlying asset’s price the trader prefers a covered call strategy. The traders are ready to limit the upside potential for getting some downside protection.
A trader buys 900 shares of BPO company at $55 per share and simultaneously writes 9 call options [1 contract = 100 shares] with a strike price of $57 expiring in 4 weeks at $0.35 per share or $35 per contract and for 9 contracts = $315. The $0.35 cost reduces per share to $54.65 [cost basis], so a drop in underlying assets to this figure will offset the received premium from the option position. In this way, the trader gets limited downside protection.
If the share price increases above $55 before expiration then the short call option gets exercised. The trader will make profit – $57 strike price – $54.65 cost basis = $2.35 per share.
There are other strategies like protective put, married put, buy-write, long straddle, protective collar, and long strangle strategies to get familiar with. However, the above strategies are basic and great for beginners.