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Option Trading Basics

Posted on July 24, 2021 by Chester Etheridge

Alternatives - An Overview

Alternatives give the buyer the right, but not the obligation, to buy (a call option) or sell (a put option) the underlying Stock or futures contract at a specified price up before a given date.

In other words, options are similar to tradable insurance contracts.

An investor can buy a Put option as insurance against a decline in the Stock price or a Call option in the event the Stock rises. Purchasing an option gives the buyer time to choose whether they will purchase or sell the underlying Stock. The purchase price is locked in before the expiry date, which in the event of LEAPS can be years into the future.

Options trading has a lot of advantages that every stock exchange investor should know about, such as high leverage, lower overall risk than owning the physical safety, more flexibility and the ability to create additional income from a present Stock portfolio.

An option's value changes in direct connection to the underlying security. The purchase price of the option is merely a fraction of the purchase price of the security and for that reason provides high leverage and reduced risk - the most an option buyer can lose is the premium, or deposit, they paid on entering into the contract.

By buying the underlying Stock of Futures contract itself, a much bigger loss is possible if the price moves against the buyers position.

An alternative is described by its own symbol, whether it is a put or a call, an expiration month and a strike price.

A Call choice is a bullish contract, giving the buyer the right, but not the obligation, to purchase the underlying security at a particular price on or before a particular date.

A Place option is a bearish contract, giving the buyer the right, but not the obligation, to sell the underlying security at a particular price on or before a particular date.

The expiry month is the month that the option contract expires.

The strike price is the price the buyer can either purchase call) or sell (put) the underlying security by the expiry date.

The premium is the cost that's paid for the option.

The intrinsic value is the difference between the current price of the underlying security and the strike price of this option.

The time value is the difference between current premium of the option and the intrinsic worth. The time value can be affected by the volatility of the underlying security.

Up to 90 percent of all out of the money options expire worthless and their period worth slowly declines until their expiry date.

This hint offers traders a very good sign as to which side of an options contract they ought to be on. . .professional options traders that make consistent gains usually sell a lot more options than they purchase.

The option contracts they do purchase are usually only to hedge their physiological Stock Portfolios - this is a strong distinction between the punters and compact traders who consistently buy low priced, from their money and near expiry puts and calls, hoping for a big payoff (unlikely) and the men who really make the money from the options market each month, by always selling these choices to them - please consider this as you read the rest of this report.

The seller of the option contract is bound to meet the contract when the buyer decides to exercise the option.

Therefore, if he's sold Covered Call options over his holdings, and the Stock price is above the option strike price at expiry, the option is said to be in-the-money, and the seller must sell his shares to the option buyer at the strike price if he's exercised.

Occasionally an in-the-money option won't be exercised, but it's extremely rare. The option seller (or writer) must be ready to sell the Stock at the strike price if exercised.

He can always buy back the option before expiry if he chooses to and compose one in a higher strike price if the Stock price has rallied, but that leads to a capital loss as he will normally have to pay more to purchase the option back compared to the premium he received when he initially sold it.

Many alternative writers simply get exercised from the Stock and then instantly re-buy more of the same or another Stock and just write more call options .

The purchaser of an option has no obligations at all - he sells his choice later at a gain or a loss, or exercises it when the Stock price is in-the-money at expiry and he can turn a profit.

The huge majority of options are held before expiry and rust in cost until there's absolutely no use from the hapless buyer selling them. Hardly any options are now exercised by the purchaser. The huge majority expire worthless.

Our choices buying strategy gave us a much bigger percentage gain with a much smaller potential risk. Do not forget though that, for us as the purchaser, these options will expire worthless if not sold or exercised by the expiry date.

The alternative seller or author only has to sit back and wait till expiry to find out if he will be exercised. If the Stock price is below the strike price at expiry, he retains the premium and can write another alternative over exactly the exact same Stock.

When the Stock price is above the strike price, he will most probably be exercised and will need to sell his Shares if he does not exit the position by purchasing his choices back to the open market (quite often at a higher price than he initially sold them for).

The drawback of purchasing the option over the physical Stock is that if you purchased the Stock itself, even if the price hadn't moved, you'd still own it, but by purchasing the alternative, if the cost does not move in the desired direction, you lose a part of your trading funds.

To earn choices trading work, the underlying security must move fairly quickly in the way you anticipate, or you may lose money at an ever increasing rate as the expiry date draws nearer.

As you can see, options strategies can provide much greater percentage returns with less risk for the identical trade. Most your money remains safely in your trading accounts instead of being exposed to the marketplace.

This is only 1 example of using options trading to raise your stock exchange returns. There are many more approaches and strategies to utilize choices and I encourage you to research them further.

All options expire worthless if they're not in-the-money at hand, so the buyer must close out or exercise his position on or before the expiry date or he'll lose the whole premium.

The time value portion of the option premium decreases gradually until expiration date. The closer to expiry, the quicker the time value decreases, since there is less time to get the choice to proceed in the desired direction for the purchaser.

For buyers, top traders counsel to not maintain an option with less than 30 days to expiry due to the exponential growth in time decay in this time.

For vendors, it's usually most rewarding to write choices which have 30 days or less to expiry, because of this exact same time decay effect. . .the buyer of those options has the odds stacked against them and will take a large price movement in his preferred direction to produce a profit - remember, the huge majority of options expire worthless - so this is the side of those instruments the wealthy usually find themselves - just a thought..