Options trading has become an increasingly popular investment strategy for both retail and institutional investors. At its core, options trading involves buying and selling call and put option contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. Understanding the fundamentals of call and put options is key to successfully trading options and implementing option strategies.
Call Option
A call option gives the holder the right to buy the underlying asset at a specified price within a specified time frame. Call options are purchased when you expect the price of the underlying asset to increase. For example, if you purchase a call option on Stock XYZ with a strike price of $50 that expires in one month, you will have the right to buy XYZ at $50 anytime within the next month, no matter how high the market price goes. If XYZ is trading at $60 when your call option expires, you can exercise the call and immediately buy XYZ at $50, resulting in a $10 per share profit. The maximum loss on a purchased call option is limited to the premium paid.
Put Option
Put options confer the right to sell the underlying asset at a specified price and within a specified timeframe to the option holder. Put options are purchased when you expect the price of the underlying asset to decrease. For example, if you purchase a put option on Stock XYZ with a strike price of $50 that expires in three months, you will have the right to sell XYZ at $50 anytime within the next three months, regardless of how low the market price declines. If XYZ drops to $40 when your put option expires, you can exercise the put and sell XYZ at $50, resulting in a $10 per share profit. As with calls, the maximum loss is limited to the premium paid for the put option.
Options traders employ various strategies using calls and put to profit from market expectations. For example, buying a call option allows you to benefit from upside gains with limited downside risk. Selling covered calls can generate income from underlying securities you already own. Spread strategies involving the simultaneous purchase and sale of multiple options can be used to hedge risks. Many traders use options to speculate on the direction of the underlying asset or to generate income from the premium collection.
If the options are not in-the-money by the expiration date, they expire worthless and you lose the amount paid as a premium. Time decay accelerates as options get closer to expiration, so most options are not held until expiration. Instead, traders close out options contracts before expiry to take profits or limit losses. Understanding the impact of time decay on option pricing is vital for success when trading options.
