There are an entire variety of strategies it is possible to follow, which range in the long term buy and hold, right through to day trading if you are trading stocks or bonds. Options trading is much the same.
Understanding just what an option is among the most tricky things to comprehend when you are starting out. Essentially, an option is a contract that gives you the right to buy (a call option) or sell (a put option) a stock or bond at a set price (the strike price) on or prior to your set date (the expiration date). You might have to read that a few times to get the hang of it!
There are various kinds of options accessible the market, with ‘American’ options able to be exercised anytime between expiration and purchase, and ‘European’ options just capable of being exercised on the expiry date. Now the place where you purchase options does not automatically mean you have purchased one sort or the other, although the terms are geographic. As a rule of thumb of them, American-style options are mainly used for bonds and stocks, whereas European-style options are for indexes.
Formally, options expire on the Saturday. Yet as US markets are close on Saturdays, that makes the Friday the expiry day that is successful. Talk about confusing!
How it works and now that you’ve got a fundamental comprehension of what an option is, let us take a peek at some fundamental strategies. I will only give attention to American-style options for stocks.
When you sell or purchase an option, you essentially have two choices – it is possible to choose to exercise it, or you’re able to hold it to maturity. Their options are held by a substantial percentage of investors before exercising the underlying asset to be traded by it. Let us look at a good example.
You have bought a call option with a strike price of $25, for $1. As options contracts are usually for 100 share lots, your purchase (blowing off commissions) would cost you $100, and you had have the right to buy $2500 of stock through the option. Because you just must pay $25 if the expiry date arrives and the stock is worth $27, it seems sensible to go ahead of purchase the stock. Meaning if you sell them instantly on the stock market you have made an instant gain of $2 per share. Yet you still must factor in what you paid to purchase the option, which was $1 a share. So after your purchase prices are deducted, your total gain is $1 a share. Well done!
But what happens if the share price does not reach at $27 – or even $26, which is your breakeven point for this option. Well, the share price is above $26 but seems to be falling and if there’s time to expiry, it may be wise to help you escape the contract to exercise the option. If the share price is under $26, you recoup some of your losses, and might have the ability to sell the options for a smaller sum than you paid, for example 20c a share. You essentially only allow the contract run the cost might jump up again, but accept that you simply’ve lost your $100 if the option has become useless. Among the great things about options is that you simply’ve just purchased the choice to buy or sell – you are not under any duty to do upon expiry. So your risk is restricted to the sum you spend purchasing the option initially.
Something to be alert to is that the price moves of the underlying assets n’t only influence option costs – their time also changed them. As the expiry date strategies, option costs often fall quickly. So if you’ve got an option which you do not need to hold until expiry, it may be worth selling out to avoid being overly badly hurt by the cost falling as expiry approaches.