Options are financial instruments whose value is based on underlying assets such as stocks or commodities like oil and gold. As such, all options contracts are derivatives that don't work without the asset they're based on. By nature, those contracts offer their holders a choice to buy or sell – though there is no obligation to do so. Other characteristics are:
- Expiration Date: last possible date you can exercise on the contract
- Strike Price: the price for which you can buy the asset
- Trading Options: typically with retail or online broker-dealer
- Two General Types: call and put options
What you should do on the expiration date depends on the style of the options contract: While European options can only be exercised on the expiration date, American-style options can be exercised at any time before expiration. This means American-style options are much more flexible, and investors can use them for sophisticated options strategies in which they have to react in real-time to short-term price fluctuation, for example.
Options can be traded on options exchanges that operate outside – or more precisely alongside – the stock market. The world's largest one is the Chicago Board Options Exchange. Its name is usually abbreviated as Cboe.
For options contracts, there are call options and put options. The former grants the holder the right to buy an asset at a fixed price and date. The latter grants the holder the right to sell an asset at a fixed price and date. Both types typically have specific types of buyers and sellers:
- Call options have bullish buyers and bearish sellers
- Put options have bearish buyers and bullish sellers
"Bullish" and "bearish" is finance jargon that describes how an investor, trader, or other people in finance take action. The former means that you believe in a positive performance, i.e., prices for your options contract are about to rise. On the other hand, the latter term describes a negative attitude towards an outcome. A bearish seller fears that his investment may become less profitable, decreasing its price, and wants to get as much profit out of it as possible before this happens.
Options trading is completely up to your discretion. If your derivative has seen price fluctuation which would mean you'd have to sell or buy at a loss, you can just write off the premium – you aren't required to exercise your option.
This characteristic is what differentiates options trading from futures trading. The latter has an inherent obligation for selling and/or buying on a set expiration date. Entering this kind of contract means an investor doesn't have the freedom to choose once the expiration date comes – unless you can sell the futures contract to someone else.
Investors looking to create an ideal risk-return profile for their portfolio can use options spread strategies. Those are usually constructed via vanilla options – options contracts without any unusual or special features – often used to take advantage of different scenarios, e.g., from down- and up-moves or low- or high-volatility environments.
One possible spread is the so-called bear call spread. It's a vertical option spread consisting of a sold call option – to collect an upfront premium – and at the same time a purchase of a second call option at a higher strike price. The collected net premium is the profit an investor makes using this strategy. Three other vertical options spreads are:
- Bull call
- Bull put
- Bear put
Bull call spread (also called long call spread): An investor buys two call options for the same asset to create a price range between a higher and a lower strike price. This effectively caps the investment's maximum loss but does the same for potential gains.
In a bull put spread (also categorized as a credit spread), a trader writes a put option and buys another lower price put option, both sharing the same expiration date. Its credit spread characteristic maximizes the gains at the net premium received at the most. But maximum loss is also capped: It's the strike price difference minus the net premium – depending on the underlying asset, this may be a relatively low risk.
The fourth classical vertical spread is the bear put spread. For this multi-leg option strategy, traders have to purchase and sell a put option, both of which share an expiration date. The latter has to be at a lower strike price for this strategy to work, though. An options trader's maximum profit, in this case, is the strike price difference minus the put premium. But loss is also capped at the premium paid for the position.
Another typical but more sophisticated spread strategy is the iron condor spread. This strategy aims at profiting off an asset's low volatility. To do so, an investor buys one short put, one short call, one long put, and one long call for the same asset – the expiration date is the same for all four contracts. Maximum profit is gained if the asset closes at the medium strike price. Also, maximum profit and loss are capped: The former at the received premium, the latter at the difference of the sold strike price minus the net premium.
All four basic strategy types can be relatively low-risk. But that always depends on many factors, such as stock price, market volatility, market situation, recent trends, premium market price, etc. It can be risky, especially for laypeople, to navigate option strategies.
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