Options trading has been around for hundreds of years, with the majority of that being in unregulated markets. When considering if an options contract is something that you should invest in, it is important to understand the basics before investing.
An option is a contract that allows the buyer of the option the right to buy or sell the underlying security at a specific price (known as the strike price) on or before a specific date in the future (known as the expiration date). This contract does not require that a buyer of the option buy or sell the security, it simply allows them the “option” to do so. The cost to purchase this contract is called the premium. The cost of the premium is determined by several factors including, but not limited to, the time until the expiration date, the volatility of the underlying security or asset as well as the intrinsic value, which is usually the difference between the securities current price and the strike price.
There are four basic types of options participants, Buyers of Calls, Buyers of Puts, Sellers of Calls and Sellers of Puts. Calls and puts are the two different types of basic options. A call provides a buyer with the right to buy a security at the strike price on or before the expiration date of the contract. Individuals that buy calls are typically bullish, or positive on that security because they are buying the “option” to purchase the security at a set price, usually with the hope of exercising that right when the security has appreciated and the value is well above the strike price.
A put provides the buyer with the right to sell a security at the strike price on or before the expiration date. Buyers of put options are typically bearish on the underlying security due to the fact that they are buying the “option” to sell the security at the strike price, with the hope that the underlying security has declined in value and is far below the strike price.
Sellers of options are often called writers of options because it is often referred to as writing an option when selling an options contract. Sellers of options contracts are different from buyers in that sellers are obligated to buy or sell the underlying security if the option is exercised. Many investors may use the selling of options to protect a concentrated position they have in an investment because sellers of options receive the premium that a buyer pays. That also could lock in gains for an appreciated security because if the option was exercised, the security would be sold at the seller’s strike price. Sellers of put options believe that the underlying security will rise, allowing them to keep the premium.
Options are often used in many speculative investment strategies and included in several other types of complex investment strategies, including hedging strategies. “Used correctly, options are a great way to participate in the market, while still protecting your hard earned wealth” according to Bill Herr of Trader Wealth Management, who has over 20 years of managing portfolio risk using options. “Used incorrectly, they can be a time bomb, particularly to the sellers of calls who don’t own the underlying stock. This is known as an uncovered call or naked call writing and can expose an investor to unlimited risk.” As with any investment, it is wise to consult with a financial professional before making any investment in order to ensure that you have a full understanding of the investment and the various risks.