Buying & Selling Options
Options, is basically a kind of derivative security. It is widely touted as a derivative security because the price of these options, are fundamentally linked to another security’s price. To put it more simply, while options can definitely be termed as contracts that grants the trader rights, yet they do not obligate the trader for buying or selling their underlying assets at a specific price before or on a specific date. In options trading, call option refers to the right to buy the asset and put option refers to the right to sell an asset. In the following section, you will get a detailed insight on Buy & Sell options.
In terms of option trading, a call option, or buy option, is often considered to be a deposit strategy for the long run. For instance, a person who deals with land might come up with their strategies and want their right for purchasing a vacant land in the long run. However, they will only prefer exercising their rights if some specific zoning laws come under consideration. This land/home dealer can purchase the buy or the call option from the respective landowner at $300,000 (for instance) at any point of time in the following three years. In this case, the landowner will not grant this option free of cost and the land dealer will have to pay a certain down payment for locking their respective right. In terms of options trading, this down payment is known as the premium, which is also the price of this contract. Considering this example, the premium can be $8000 and the developer pays this amount to the landowner. In the course of one year, the zoning gets approved and the developer exerts his right to buy the land at the pre-settled price, although the market price of this plot has increased. There can also be an alternative situation where the zoning is not approved till the fourth year, which is one year after the expiration of the existing option. In this scenario, the developer has to buy the land at the market price. However, in either case, the owner of the land gets to keep the premium of $8000.
The put option, or the sell option, is more of an insurance policy. Let us consider an arbitrary situation where the land dealer has a huge portfolio of stocks for blue chips in their account. He, however, is worried about an impending news regarding recession in the coming two years. He wants to be assured of the fact that even if the market is subjected to a massive com hit, he won’t lose more than around 10% of the value of his portfolio. If the index of S and P here is 500 and the trade is being carried out at 2500, the land dealer can purchase his sell or put option which will give him the option to get his index sold at 2250 during any time in the following two years. Now, if the market crashes by twenty percent, six months down the line, then he would have been able to make around 250 points by getting his index sold at 2250 even while the trader was investing it at 2000. Here, he will only experience a loss of 10%. At this point, even if the market happens to drop to zero, he will not lose more than 10% owing to his put or sell option. Here too, the purchasing option will come with a premium and if the market is stable at that point, the specific premium is lost.
Advantages & Disadvantages Of Call Options
- Better leverage- Call option comes with a premium which is far less extravagant than its underlying security. The leverage that results from it further boosts your prospective returns from the investment.
- Lesser risks- Call options come with a risk because there is a possibility that the option does not cross the strike price, before it expires. However, then too, the maximum limit of your risk is the premium because the most you can lose is the amount you paid as premium.
- Get your calls covered- When you purchase a call option, you can end up generating extra amounts by swapping roles, keeping a specific position of the stock and selling the contracts of your call option.
- One of the major risks of purchasing call actions is simply the fact that your option does not cross the strike price, before it expires. In that case, not only do you lose the premium money, but you also lose a large amount of time.
Advantages & Disadvantages Of Put Options
- Lesser risk- When you buy a put option, you will learn that the maximum risk you can experience is against the initial cost of your put.
- Quick insurance- Put option will act as an insurance policy as the options will be paid to you, right when you purchase them.
- No issues with dividends- As put holder you won’t be liable for any new dividend that is paid via stock.
- Better profit- Put options always come with a relatively greater financial return because when you buy this option you are paying a lesser amount with respect to the value of the underlying stock.
- The primary disadvantage of the put option is the very fact that it comes with a limited life. This option can also expose you to greater losses.