You can use two options in options trading: a call option or a put option. A call option gives you the entitlement to buy an underlying asset at a specified price within a specific period. In comparison, a put option is an agreement that gives the holder the right to sell an underlying asset at a specified price within a specific period.
Both call and put options are contracts between two parties, and each type of option has its benefits and risks. Call options are often used to speculate on the future price of an asset, while put options are often used to hedge against potential losses.
Before entering into any options contract, it’s essential to understand all of the terms and conditions involved. It includes understanding the underlying asset, the strike price, the expiration date, and more.
What are some key terms in options trading?
Underlying asset
The security or other asset that the option gives the holder the right to buy or sell.
Strike price
The price at which the underlying asset can be bought or sold, as specified in the contract.
Expiration date
The date on which the option expires and ceases to exist.
Intrinsic value
The amount by which the current market price of an underlying asset exceeds the strike price of a call option or the amount by which the strike price of a put option exceeds the current market price of the underlying asset.
Extrinsic value
All other considerations aside, intrinsic value is the only component of an option’s premium that represents a benefit to the holder. All else being equal, the extrinsic value will decrease as expiration approaches.
Risks involved when trading call options
Traders may struggle to find a buyer
Unlike stocks or ETFs, which can be sold at any time during the trading day, options have a limited window of opportunity. Once an options contract expires, it ceases to exist. It means that traders holding on to an option may have difficulty finding a buyer when they want to sell.
The underlying asset may not reach the strike price
If a trader buys a call option and the underlying asset doesn’t reach the strike price by expiration, they will lose the premium paid for the option. However, if the underlying asset does reach the strike price, the trader will make a profit equal to the difference between the strike price and the market price, minus the premium.
Time decay
All options contracts lose value as expiration approaches. The extrinsic value comprises two factors: the time value and the underlying asset’s volatility. As time goes on, both of these factors decrease, leading to a decrease in extrinsic value. It means that call options become less valuable as expiration gets closer.
Risks involved when trading put options
The underlying asset may reach the strike price
If you bought a put option and the underlying asset reaches the strike price by expiration, you will make a profit equal to the difference between the strike price and the market price, minus the premium.
Traders may struggle to find a seller
Just as with call options, put options have a limited window of opportunity. Once an options contract expires, it ceases to exist. It means that traders holding on to an option may have difficulty finding a seller when they want to sell.
When to use call options
If you predict the price of a stock, ETF, or other assets will increase, you can buy a call option. It will give you the right to buy the asset at a specific price (the strike price) on or before a specific date (the expiration date). If the underlying asset’s market price is above the strike price at expiration, you will make a profit.
When to use put options
If you predict the price of a stock, ETF, or other assets will decrease, you can buy a put option. It will give you the right to sell the asset at a specific price (the strike price) on or before a specific date (the expiration date). If the underlying asset’s market price is below the strike price at expiration, you will make a profit.
