Learning the Inner Workings of Options Contracts

Learning the Inner Workings of Options Contracts

Learning about derivatives and options may be a difficult task for many, but it will get easier. In this article, we’ll talk about the most basic workings of these derivatives as well as their types and categories. 

Demystifying Options

Basically, what you have to remember is that an option is the chance to participate in any prices changes in an asset.

That means if you own a call option, you can participate in the uptrend of the stock—without actually owning the stock.

When it comes to valuing these contracts, it’s practically all about spotting the chances of future price events.

For example, the value of a call option goes up as the value of the underlying stock goes up. Remember this to find the relative value of options.

Bear in mind that the less time until expiry, the lower the value of the option. As we come closer to the expiration date, the chances of a price move in the stock decreases.

This is the reason why options are also ‘wasting assets.’ If you buy a one-month option and the stock doesn’t move, the option becomes less valuable by the day.

If that’s the case, why do investors still use options contracts?

Speculation

Speculation is basically betting on future price direction. An investor who is also speculator might think of the price of a stock and believe that it will go up, probably because of its fundamentals or technicals.

That speculator may buy the stock directly. OR buy a call option on the stock.

Using options for speculation rather than buying the stock directly is appealing to many traders. That’s because the options offer leverage.

An out-of-the-money call option can cost a few dollars. Sometimes it’s just cents. You can compare that to the full price of a $100 dollar.

Read further: Options and Futures: Differences and Strategies

Hedging

Options essentially exist for the purpose of hedging. Hedging with the use of these can reduce risks, and that comes with a reasonable cost. As such, you can think of options as insurance policies.

On the other hand, the critics of options may claim that “if you are not sure of your stock pick that you need to hedge, don’t make the investment.”

However, the reality is that there is lots of evidence that hedging can be very useful. This is true when it comes to the case of large institutions. You can also benefit from hedging.

Suppose that you want to buy a technology stock but you also want to limit your losses. When you use options, you could put a cap on your downside risk and benefit from the outside with low costs.

In the case of short sellers, call options can be helpful when the market doesn’t go according to forecast.

Spreads

Spreads use two or more positions of the same class. In a nutshell, they combine speculation and hedging, or having a market opinion and limiting losses.

Spreads usually limit your potential upside too. However, these strategies can still be effective because they typically are inexpensive.

Vertical spreads work by selling one option to buy another. In general, one option has the same type and same expiration as the other. Their difference lies in the strike price.

Spreads, therefore, can really show you the flexibility of these derivatives. You may even construct your own kind of spread to fit to almost all types of market movement and condition.

American and European Options

options trading written on paper with foutain pen on top

There are differences when it comes to the categories of options contracts. You can exercise American options anytime between the purchase date and the expiration date. Most options that trade on exchanges are American.

European options are different from American ones since you can only exercise the former at their expiry.

To be clear, the difference between American and European options has nothing to do with geography.

Many of these that trade on stock indexes are European type. Since the right to exercise early on has some value, an American option usually carries a higher premium than an otherwise identical European option.

Expiration & Liquidity

You can also categorize by their duration. Short-term options are thosethat generally expire within a year.

Long-term options with expiration longer than a year are long-term equity anticipation securities, or LEAPS.

LEAPS are similar to regular options, only with longer durations. Even if they are not available on all stocks, LEAPS are available on most popular or common issues.

Bear in mind that LEAPS are typically less liquid than shorter term options. That means they are not good for short-term trading.

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