What Is An Option (In Trading)?

A trading option is a financial contract that secures your right to buy or sell shares or securities but does not obligate you to proceed with the transaction.

Furthermore, the price and period to conduct the transaction are predetermined in the option or contract, and you cannot exceed these parameters. In addition, you’re charged a premium for the privilege of using the service from a broker.

Here is a list of the best options brokers in the UK if you’d like to learn more. Furthermore, options allow you to hedge the future prices of securities and, should the market not turn out as you’d expected, enable you to abandon your position without taking a significant hit. We’ll also explore other aspects of options trading and let you know the pros and cons. So keep reading to learn more. 

Types of Options

Call Option

Call options are financial contracts that give you the right but do not obligate you to buy specific securities at a set price and within a given period. They are primarily used to hedge and speculate on financial assets. Long calls, in particular, have excellent upsides while limiting your downside to just the premium. 

For instance, imagine you’re looking at company X’s shares that you think will rise tremendously in the next few months. However, you’re in the middle of renovating your house and can’t afford to take the $20,000 required to make the investment you want at the time. Which is 200 shares at $100 each. 

Now, let’s assume a call option premium on company X’s shares is one 100-shares option at 30% of the share value. To hold the same position as your initial investment aspirations, you would need to buy two options at $3,000 each to end up with 200 shares, which would only cost you $6,000.

One last thing to note about call options is that they tend to have bullish buyers and bearish sellers, which technically means you have the upper hand as the buyer. 

Put Option

A put option is a financial contract that allows you to sell your shares at a specific price point but gives you the right to hold on to them for a particular period. If call options give you the advantage when you’re buying, put options give it to you when you’re selling. As such, sellers tend to be bullish while buyers are bearish. 

Put options are an excellent strategy to implement when shorting a stock. Because the value of your position will increase as the price drops, and you can afford to be a bit bullish, knowing you have hedged your bets at a set minimum price if it rises. 

How Options Work

  • Call options buyers are hedging from dropping prices while put options from rising. 
  • Importers into the US use call options to hedge against a decrease in their purchasing power from a dropping dollar, while exporters against a rising dollar. 

What are the Pros and Cons of Options

Pros

  • They limit losses to only the premium.
  • Their upsides are limitless. 
  • They allow you to get in large positions even when you cannot cover them at the time. 
  • They give you room to do more with your investment capital. 
  • They enable you to make more than while buying the same amount of shares directly. 

Cons

  • Options expire with time, and your premium will be wasted if the stock does not move within that period. 
  • They are complex and can also be difficult to price. 
  • They require a deep understanding of investment strategies. A lack of knowledge can lead to devastating consequences. 

Conclusion

In today’s trading world, investment strategies come in many different forms, and it might seem like there are ways to help you hedge any positions you hold. For instance, look at options, they might sound complicated at first, but all they are at the end of the day is a way to help you be more successful while mitigating your risks. Furthermore, if you take the time to learn and understand options trading strategies, you can significantly diversify your investment portfolio while keeping your risks relatively low. 

So what do you think about options trading, and will you be giving them a try? Let us know in the comments section below.

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