When it comes to investing, most feel that an investor’s portfolio is made up of three things: mutual funds, stocks and bonds. The variety of securities does not end there for sophisticated investors. Options are another kind of investment; their power lies in versatility. They are considered very complex and risky, and at first can be quite intimidating. Especially, when you see a disclaimer like the following:
“Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.”
These aren’t reasons for one to completely omit the idea of trading options, especially since options pop up quite often in the investment world. Most large corporations use options heavily; whether in foreign-exchange transactions or employee ownerships. Understanding and knowing how options work is essential, it is just as dangerous to remain ignorant as jumping in. This is why a sound financial education on the matter is crucial to help navigate the unpredictable waters of options.
As complicated as options seem, traders do come to appreciate two important aspects of it once mastered. Firstly, due to its versatility and predictability, you can structure your trades so that in advance you are aware of your maximum losses. Secondly, through options you can get big profits or losses on a modest investment. How? Options are leveraged. For a relatively small portion of total asset cost such as stocks, you can control large amounts of asset. Profit can also be gained from options through theta or time decay.
A “call option” is a kind of option which comprises of a financial contract between two parties. The “buyer” and “seller”. The buyer has the right, but not obligation, to buy a financial instrument or commodity from the seller of the option. The price paid for the option -the premium- gives the right to buy, let’s say 100 shares of underlying stock, at a certain time (on, or before the specified expiration date) for a certain price - the strike price. When buying an option, your maximum loss is the purchase price. The riskier time is when selling an option. If not knowledgeable on the matter, you can lose many times your investment. Which is why, once again, a good financial education is important before dipping your toe in the water.
Similar to a call option is a “put option”, except rather than buying the 100 shares at strike price, you buy the right to sell them.
Before an option expires, it can gain intrinsic value which results in a concept called “Call Time Value”. Time value is highest when the amount of time to expiration is at its highest, and decreases as the expiration date draws near – This is called theta decay. When the time value is higher, the stock has more time to cross the option’s strike price. Compared with options expiring in the future, those options expiring within the current month have an accelerated theta decay. Options expire on the third Friday of their expiration month.
A strategy called “Covered Call Writing” is used to extract value from theta decay. A conservative way to earn income is to sell calls on shares owned by you and collect the option’s premium (which you are always allowed to keep). The one thing it can’t protect you from is a price collapse on stocks you own. You can benefit from an accelerated theta decay by selling a call which expires within 30 days. In this way the calls will expire worthless and you can keep your shares, repeating the strategy in the next month. Sometimes the options expire with intrinsic value when they exceed the strike price at the expiration date. In such cases, your shares are called away for the strike price.
If you have acquainted yourself with the kinds of option strategies and trades from an educational background in finance, you can pursue more advanced strategies like “calendar spreads”. In this you predetermine your maximum loss on a calendar spread, and sell and buy calls at the same strike price but different expiration dates.
This is a risky path to tread. To safely profit from all aspects of trades it is imperative that one increases their understanding of the process and hence your ability to safely profit from a situation and save from losses.
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