Puts and Calls: Essentials to Know About Options Trading

Puts and Calls: Essentials to Know About Options Trading

The stock market can seem like a daunting place. The terminology alone is enough to give amateur investors a sense of trepidation. While there are some extremely complex instruments out there, the basics of buying and selling on the stock market are as simple as they’ve ever been.

Options may sound complicated, but when you are buying an option, essentially you are paying a certain amount of money to lock in a price, be that the buying or selling price of the stock, for a specified period of time. By understanding and utilizing options, traders can turn a high profit on a limited outlay, or ensure limited exposure to volatile market conditions by “hedging” a trade.

Puts and Calls

You buy a “put” when you expect a share to drop in value. Essentially you are buying the option to sell the stock at a fixed price. If the stock value drops during that expiration period, you retain the option to sell it at the higher price, thus making money on the transaction.

A “call” option, on the other hand, allows you to buy the stock in question at a given price. You would purchase a call option when you anticipate a stock’s price will rise within the expiration period. As the stock price rises, you have the option to buy the stock at the price agreed upon at the time of purchase. By cashing in your option to buy at the lower price, you can then turn around and sell it at the current price, resulting in net profit.

Potential Benefits from Options

Options provide a number of benefits relative to buying actual shares in stock. An option can return profit in any market, bear, bull, or flat. Purchasing options is also a method to maintain value when a given stock price is unstable. By purchasing the option to sell at a higher price, the stockholder insures the stock has a given value even if the underlying stock price takes a tumble. Options can be used to generate immediate returns on a portfolio. By placing options on one’s own positions, the savvy trader can create liquidity, as the bedrock of the portfolio remains untouched. Finally, stock options can be purchased and exercised in order to create substantial amounts of profit in a very short time.

Inherent Risk Factors

Most of the time stock options are not exercised. Because they are often use as a hedge, if the underlying stock is performing well, the option is allowed to expire. its purpose as a short-term insurance policy has been realized and no one is exercising the right to buy. But when a trader takes a position on an option, they are ultimately responsible to buy or sell those shares at the established price should the trader on the other end of the option decide to exercise it. In this case, the trader holding the other end of the option is responsible to produce those shares at the established price, sometimes to the tune of quite a lot of money and loss.

Option trading is an important tool in the trader’s kit. While no instrument is without risk, options can give the trader a sense of security and stability, or allow for the generation of significant returns.