when trading volume or volatility is relatively low and the market is trending upward traders often buy one or more calls since call options tend to appreciate in value as the underlying asset s price rises meanwhile traders tend to buy puts when volume or volatility is relatively low and the market is trending downward since puts increase in value when the market declines during market downturns option traders often sell calls while they sell puts when the market is advancing 5
american options can be exercised any time before the expiration date of the option while european options can only be exercised on the expiration date or the exercise date hedging and speculating with options contractsoptions can be an effective tool for hedging as they allow investors to protect their investments against downside risk while retaining the possibility of upside gain typically hedging involves taking an offsetting position in a related security such as a call or put option suppose you re a portfolio manager focusing on equities you want to protect the portfolio from a potential downturn and might buy put options for the stocks on the portfolio if stock prices fall the put options will increase in value offsetting the losses in the portfolio options are also widely used for speculative purposes because of their inherent leverage since options allow you to control a large amount of a stock or other underlying asset through a relatively small premium they can offer increased speculative prospects suppose you expect a company s stock price will rise and buy call options if the stock price increases beyond the strike price of the options you earn a profit that is a multiple of the initial premium paid on the other hand if an investor believes a stock s price is about to fall they might buy put options a drop in the stock price below the strike price can lead to significant gains relative to the initial premium let s put this idea of leverage into action suppose abc stock trades at 100 per share you think that the price is about to jump in the next month you can do two things now let s fast forward one month and assume the stock price has risen to 120 per share congratulations your analysis was correct if you took the first choice above you would profit 2 000 less fees and taxes 120 100 100 shares in the second scenario the option you bought at the money is now in the money the likely price for the one call you bought would now have risen to 20 per contract 20 x 100 2 000 less the premium paid of 200 for a total gain of 1 800 but say instead you had decided to spend the 10 000 on the same option position and all the variables remained the same the initial 10 000 would have got you 10 000 200 50 option contracts when the price of the underlying rises to 120 per share the options would have likely risen to 20 x 100 2000 per contract you bought 50 contracts and therefore the total price of the position would be 2 000 x 50 100 000 less the cost of the options 200 x 50 10 000 total profit without factoring in fees and taxes 100 000 10 000 90 000 this shows you the potential for profit using the leverage that options trading allows however options are a wasting financial instrument and are therefore subject to increased risk of loss one strategy options traders use is called a protective put this is a popular strategy because it generates income and reduces some risk of being long on the stock alone to execute the plan you buy the underlying asset as you usually would and simultaneously write or sell a call option on those same shares options contracts risks and rewardsoptions trading involves strategies ranging from basic hedging or protective measures to complex speculative ventures while the potential for profit with options can be substantial the risks are significant calls and puts are potent tools to improve or protect a portfolio s performance against losses however they require an excellent understanding of market dynamics and the factors influencing option pricing such as time decay and volatility before participating in options trading you should understand whether the market conditions and underlying securities are favorable in addition consider the time frame involved you should try to match the option s expiration with the expected timing of the asset s price moves finally you need a clear plan for when to sell or exercise the option based on the asset s performance if an option reaches expiration with a strike price higher than the asset s market price it expires worthless or out of the money call options risks and rewardstrading call options can involve high risks there is a potential loss of the entire premium paid if the stock doesn t rise above the strike price by expiration the call option will expire worthless resulting in a total loss of the premium there s also the risk of time decay options are time sensitive instruments the value of call options erodes as the expiration date approaches which can result in losses if the stock s price doesn t rise above the strike price by expiration moreover call options are sensitive to volatility the price of call options can fluctuate widely because of price changes for the underlying stock high volatility can increase premium costs that are not linked to favorable moves in the stock price despite these risks call options have several advantages buying call options gives you more control over a relatively larger amount of stock than just purchasing the stock outright for the same amount this leverage means that returns can be amplified in addition the maximum loss for buying call options is limited to the premium paid no matter how much the underlying stock decreases in price lastly calls can be used for various strategic purposes including speculative gains income via premium collection and as part of more complex options strategies put options risks and rewardsjust like call options put options can expire worthless leading to a total loss of the premium paid this can occur if the stock price remains above the strike price also put options suffer from time decay meaning that they lose value as the expiration date nears particularly if the stock price is not moving as expected in highly volatile markets the cost of puts can go up making them an expensive form of insurance nonetheless there are rewards for employing put options puts provide a way to profit from a decline in the stock price without needing to short the stock which can involve further risks and costs puts can also protect you from declines in other investments in a portfolio by offsetting potential losses in the value of the underlying stocks lastly like calls buying puts has a risk limited to the premium paid offering a predefined risk profile example of an options contractcompany abc s shares trade at 60 and a call writer is looking to sell calls at 65 with a one month expiration if the share price stays below 65 and the options expire the call writer keeps the shares and can collect another premium by writing calls again if however the share price appreciates to a price above 65 the buyer calls the shares from the seller purchasing them at 65 the call buyer can also sell the options if purchasing the shares is not the desired outcome 