For new investors, options trading, like the stock market in general, can appear complicated at first glance. But once you start to understand them a bit more, it becomes quite an attractive opportunity.
If you are looking to hedge your portfolio, generate income, or speculate on stock movements, understanding the basics of calls and puts gives you a great chance of being successful.
So, to help you on your way, we’ve put together this beginner-friendly guide on what options are, how they work, and how you can use them effectively.
What is Options Trading?
Options are an agreement contract that affords buyers the right to trade securities like WBC:ASX at a definitive price at a future time.
Essentially, option holders pay a premium price on the proviso that they can buy or sell the security, within a particular period.
Typically, if option holders find that market prices become unfavourable, they will not exercise the right to trade the options. Preferring instead to let it expire as worthless in an attempt to make sure any losses are not more than the premium.
However, if the market booms, they can choose to exercise their contractual right.
Understanding Calls and Puts
Overall, there are two main types of options – calls and puts. Here are the main characteristics and distinctions of both.
Call Options
A call option gives the buyer the right to purchase an underlying asset at a specific price (known as the strike price) before the expiration date. Effectively, it involves reserving a stock at a set price in the hope that it will increase in value.
How Call Options Work:
When you buy a call option, you do so with the expectation that the stock price will rise above the strike price before it expires.
If the stock price increases significantly, you can exercise your option to buy the stock at the lower strike price and sell it at the higher market price in an attempt to make a profit.
However, if the stock price does not rise above the strike price, the option will expire as worthless, which means you lose the amount paid to purchase the option.
Example of a Call Option:
Imagine you buy a call option for a stock with a strike price of $50, which expires in one month, and you pay a premium of $2 per share.
If the stock price rises to $60 before it expires, you can buy it at $50 and sell it for $60, therefore making a $10 profit per share (minus the $2 premium).
Put Options
A put option gives the buyer the right to sell an underlying asset at a specific price before it expires, which can be a useful tactic for those who believe its stock price will decline.
How Put Options Work:
Typically, those who buy a put option expect that the stock price will drop below the strike price before it expires.
If the stock price falls significantly, you can exercise your option to sell the stock at the higher strike price to make a profit.
That said, if the stock price does not drop below the strike price, then the option expires as worthless, and you lose the premium you paid.
Example of a Put Option:
Suppose you buy a put option for a stock with a strike price of $50, which expires in one month, and you pay a $3 premium for it. If the stock price then drops to $40, you can sell it at $50, which will make you a $10 profit per share (minus the $3 premium).
How to Use Calls and Puts in Your Strategy
Depending on your investment goals, you can use options in several ways. Some of the main ones are as follows:
- Speculation
Many traders use options, particularly if planning for retirement, to bet on stock price movements in the following ways.
Essentially, if they believe a stock will rise, they will buy a call option. However, if they think it will fall, they purchase a put option. Either way, this approach allows them to potentially profit without owning the stock.
- Hedging
Some investors use options to protect their portfolios from losses. For example, if they own a stock but worry about the potential for it to decline, they can buy a put option to minimise their losses.
- Generating Income
Some traders sell options to collect premiums. By selling covered calls (writing call options on stocks you own) it can provide them with additional income.
Risks of Options Trading
While options offer opportunities, like the rest of the stock market as a whole, they do carry risks.
Due to the limited timeframe, options frequently expire. So, if the stock does not move in your favour within that period, the investment will tank.
In addition, while leveraging risk can definitely result in significant gains, it can also increase the potential for losses. This is particularly true in the case of those who don’t have in-depth knowledge or experience in managing options.
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