What are options trading?
Options are contracts that give an investor the right but not an obligation, to buy and sell an underlying instrument like stock or even index at a predetermined price over a certain period of time. In options trading, a fixed premium amount is paid by the buyer to the seller. You can buy options in a brokerage trading account as you buy most of the other assets.
The amount that sellers charge from buyers to hold a stock is called a premium. This premium price gives the buyer the right to book the stock under no obligation to buy the stock in future. In unfavourable conditions, the buyer can let the option expire. In such conditions, this loss equals the premium price paid by the buyer.
A good portfolio is a blend of several asset classes including stocks, bonds, ETFs and mutual funds. Options are assets that can offer you higher returns compared to trading stocks and ETFs. Also, in options trading, the profit limit is not fixed but the loss limit is fixed. The maximum loss an investor can have is equal to the price of the premium. Therefore, it becomes important to learn options trading.
How does options trading work?
Let us see an example to understand how options trading works.
Future and option trading example 1
Suppose you are going to buy a car. On your way to the showroom, you called your friend and told him that you are going to purchase a car today. Your friend tells you that prices are going to increase by next week.
After reaching the showroom, you ask the salesperson about the car that you are looking for in red colour. The salesperson tells you that the car is available but not in red. He also assures you that the red colour will be available by the next week. But you recall your friend’s words that prices will increase by next week. So you ask the seller if the prices will increase. He says that prices are going to change next week but is not sure whether the price will increase or decrease.
He also told you that you can book the car today at the current price by paying a non-refundable booking amount. This will give you the right to buy the car next week at the same price at which you booked the car and not the updated price. So you decided to pay the booking amount and book the red car.
Suppose on the day you booked the car, the price of the car was $8000. You paid the seller $100 as the booking amount. After one week the price of cars has decreased rather than increasing. And now the new price of the car is $7700. In this case, will you buy the car at the price of $8000? Or will you leave the $100 that you have paid to the seller and buy the car without the previous agreement? Obviously, buying a new car without a previous agreement is a better option, because it will still cut down the buying cost by $200.
Had the price increased by $300, the new price of the car would have been $8300. But still, you would have got the car for $8000 because of the previous agreement.
In the previous example, we have seen that an agreement can be made between a buyer and seller at a predetermined price for a commodity for a certain period of time. Now let us see what happens in the case of the share when we make an agreement with the seller.
Suppose you like a car company that is going to be sponsored on a large scale for an event next week. You are sure, if the event happens, the share price of the company will shoot up from $100 to $200 and this will boost your profit. But you don’t want to buy the shares today at $100 because there are two more companies in competition for the sponsorship. If your favourite company didn’t get the sponsorship, the price of its shares will reduce to $50 by next week. Therefore, you don’t want to take a bigger risk.
But the seller makes you an offer, where you have the option to buy the shares at today’s price (i.e. $100) after the announcement of the sponsorship results. But to make the offer you have to pay a premium price of $20 to book the deal. After making the deal with the seller you have the option to buy the stock for $100 irrespective of the result of sponsorship. That means the price of the stock will be fixed at $100 for you.
Case 1: When the company gets the sponsorship
In case your favourite company got the sponsorship so its share price has increased from $100 to $200. You will still get its shares at $100. But, you have paid a $20 premium to the seller, therefore your total profit will be $200 – $20 – $100 which equals $80. That means for a $200 share you have to pay $120. Therefore, your profit is minimised because of the premium amount.
Case 2: When the company does not get the sponsorship
Consider a case where your favourite company does not get the sponsorship. The price of its share will go down from $100 to $50. In case you have had purchased the shares before you would have faced a loss of $50. In options trading, you have the right to decide whether you want to buy them or not. But why would anyone buy a share by paying more than the market price? If you still wish to buy the shares of that company you will directly buy them from the market. You have booked the shares by paying a $20 premium, therefore your loss is also minimised to the premium price.
Calls vs Puts
Options trading is based on buying or selling a stock on its future value. It is of two types
If you are buying call option then you are a call holder, whereas when you are selling call option you become a call writer. Similarly, when you are buying a put option it is known as a put holder, while, if you sell the put option then it is known as put writer.
- Buying calls and selling puts indicates that you are bullish in nature.
- When you are a call seller or call writer you take a short position that indicates you are bearish by nature. The call writer believes that the prices will go down.
- Similarly, when you buy a put option it indicates that you are bearish by nature.
The call option gives the buyer the right but not the obligation to buy the stock at a strike price, whereas in ‘puts’ the seller has the obligation to sell the stock to the buyer if the buyer exercises the option.
Call option example
You pay token money to a seller to book a property that you will buy over a fixed time at a fixed price. The seller is bound to sell you the property no matter if the prices of the property go up or down until the contract expires. But you have no obligation to purchase the property. Whether you buy or not your token money will not be returned.
The put option is a contract between buyers and sellers to exchange a stock at a strike price by a predetermined date. The buyer of the put option has the right but not the obligation to sell the stock at a predetermined price by a specific date whereas the seller of the put option has the obligation to buy the stock from the buyer at the strike price if the buyer exercises his option.
Put option example
Let’s say you have a property and you believe that the property rates may go down in the next two years. So you invested a small amount in buying an insurance policy for the property. This insurance policy assures you that if the price of the property reaches or goes below the strike price the insurance company will bear the loss until the contract expires. Here the buyer of the insurance policy has the right but not the obligation whereas the seller of the put option has the obligation if the buyer exercises his option.
How to buy options
Long term investors invest by purchasing shares at a market price whereas options traders can buy shares at the strike price and not the market price. Let us see how to buy options as it can be another tool for you to invest and grow your money.
Call Option Definition
A call option is a contract between an option writer (seller) and an option holder (buyer) that gives the option buyer a right to buy (not an obligation) a stock/underlying asset at a predetermined price by a prespecified date.
Call option example
When you buy a call option you have to pay an advance/booking/registration/premium amount. It is a non-refundable amount that you need to pay. In options trading, this amount is known as premium. Now let us understand the buy call option and sell a call option by example.
Suppose you want to buy an apartment that cost $300000. As per the market research, you believe that its price will increase in the next two years because a shopping mall is going to be built near the apartment. But you are not sure about it.
So you pay the broker $5000 to book the apartment for you at $300000 for the next two years. It means the broker has an obligation to sell you the apartment for $300000 until the contract expires. Also, if the price of the apartment increased then also the broker is bound to sell you at this price.
After 2 years, if the shopping mall is built or started to construct, the price of the apartment will increase. Let us say the price of the apartment in two years increases to $350000. But due to the previous agreement, the broker is bound to sell you the apartment at $300000. Therefore, your net profit is equal to
Net Profit = $350000 – $300000 – $5000
Net profit = $45000
In case a shopping mall is not built, let’s say the price of the apartment goes down to $250000. You have the right not to buy the apartment, therefore your total loss is limited.
Total loss = Premium
Buy call option (Long call option)
- You should buy a call option when you are bullish on the stock/index/underlying asset.
- Limited loss and unlimited profit
Let’s say the spot price of a share is $90 on January 1, and you expect the price to increase by February 1. So you want to lock the price of that share for a month at $100. To lock the price you have to pay a premium of $10 that will be valid for one month.
In this case, your strike price is $100 and the expiry date is February 1.
- If the spot price goes below the strike price, then the maximum loss is equal to the premium you paid i.e. $10
- When the spot price is between $100 and $110 then your loss is minimizing.
- When the spot price of the stock goes beyond $110 then you will book profit.
Profit or Loss = Spot price – Strike price – Premium
At the money (ATM)
Strike Price = Spot Price
Maximum Loss = Premium
In the money (ITM)
Spot Price > Strike Price
Profit = Spot price – Strike price – premium
Profit = 120 – 100 – 10
Therefore, profit = $10
Breakeven point = Stike price + Premium
Profit/Loss = Spot price – Strike price – Premium
Profit/Loss = 110 – 100 -10 =$0
Therefore, at breakeven point no profit no loss.
Out of the money
Spot price < Strike price
Maximum Loss = Premium
Sell Call Option
Now let us see how to sell a call option.
In the previous example, if the broker had been bearish, he would have sold the call option. That means if the broker believes that prices are going to decrease in the next week he would have taken the premium amount knowing that the buyer will not exercise his option and he can make a profit by taking the premium amount. But if the price of the stock increases the broker do not have any direct loss but an opportunity loss.
- You should sell the option when you are bearish on a stock/index/underlying asset.
- Limited profit and Unlimited loss
Put option definition
A put option is a contract between an option writer (seller) and an option holder (buyer) that gives the option buyer a right to sell (not obligation) a stock/ underlying asset at a pre-determined price by a pre-specified date.
Put option example
A put option is similar to insurance. Let us suppose you bought an insurance policy for your car. As per the insurance agreement, the insured declared value of your car is $7000. It means if the car is completely damaged the insurance company will owe you $7000. Let’s say the premium price of the insurance company premium is $300 for 1 year. There can be two cases.
The car is completely damaged in an accident and you get a scrape price in the market that is $700. But you remember the premium you paid before. So you claim in the insurance company and your option is executed. Here, you have the option, but not the obligation to claim your insurance.
If you take the insurance claim you will get $7000. Then your profit will be
Profit = (7000 – 700 – 300) = $6000
This is how a put option works.
In case the car had no accident or very few scratches within one year. So this option will not be executed and the loss is equal to the premium amount you paid i.e. $300.
Buy Put Option
- Buy a put option when you are bullish on a stock/index/underlying asset.
- Loss is limited to the premium price and profit goes up till the stock price reaches $0.
Let us understand the ‘buy put option‘ with the chart provided. If the stock price is $110 on January 1 and you believe that the price will go down by February 1. Therefore you buy a premium of $10. In this chart, we can see the strike price of the stock is $100. It means we have the right to sell the stock at $100 within one month.
Here you purchased a premium of $10 assuming that the market will go down by next month. Let us assume that the spot price increases next month, then the total loss is equal to the premium amount.
But suppose the spot price falls below the strike price then you will book your profit.
Let us say the spot price is $70
Profit = Strike price – Spot price – premium
Profit = 100 – 70 -10
Therefore profit = $20
At the money
When Spot price = Strike price
Therefore, your loss is equal to the premium price.
In the Money
Strike price > Spot price
The area left-hand side of the strike price comes under “in the money”. It means you are moving towards profit but not necessarily making a profit.
When the spot price is $70
Profit = Strike price – Spot price – Premium
Profit = 100 – 70 – 10
Therefore profit = $20
But suppose the spot price is $95 then
Profit = Strike price – Spot price – Premium
Profit = 100 – 95 – 10
Therefore Profit = -$5 which means you had a loss of $5.
Out of money
Spot price > Strike price
Maximum loss = Premium price
BE = Strike price – Premium
Profit/Loss = 100 – 90 -10 = $0
Therefore there is no profit no loss.
Sell Put Option
- You sell put option when you are bullish on stock/index/underlying asset.
- Your profit is limited to premium price and loss is up to stock price going to $0.
Best options trading platform
Options trading offers much higher returns as compared to stock trading and that’s why more and more people are attracted to options trading. Here is a list of the top 3 best options trading platform to begin your options trading journey.
- IQ Option
Iq Option is one of the fastest growing online trading platforms that offer CFDs on stocks, ETFs, Forex, indices and cryptocurrencies. Founded in 2013, the IQ option has grown enormously and today they have more than 40 million users.
To start trading on IQ Option follow these simple steps.
- Register on IQ Option for free.
- Learn and practice with a demo account.
- Start investing with a minimum of $10.
Binomo is a world-class trading platform that offers the highest quality support including professional level tutorials, analysis and client support. The brand understands that the quality of the trading platform is proportionate to the trader’s success hence, the emphasis is on higher quality service. There are a lot of benefits of the Binomo platform like you can start making trades at minimum investments, no restrictions on the platform regarding the number of trades etc.
Binomo offers a demo account where you can improve your trading skills. And when you are ready, you can switch to a real account and start trading. It also gives you online chat support.
To start trading with Binomo follow these simple steps.
- Register on Binomo and open your account.
- Prctice with demo account.
- Switch to real account when you are ready.
Binarycent is a popular option trading platform that is used by most options traders. It provides trading with all the top cryptocurrencies like Bitcoin, Dash, Zcash, Ethereum, Monero, BlackCoin, Reddcoin etc. You can start trading from 10 cents.
It is a top-notch and easy to use platform which’s why it is liked by many online traders. Binarycent provides technical indicators, drawing tools, time frames and other settings traders possibly need. Also, you can customize the chart for your ease.
Deposit and withdrawal are very easy. The brand accepts wallets, credit cards and wire transfers. For easy and faster withdrawals, one can even use cryptocurrencies. The best part is that Binarycent offers a bonus for every new client.