What are the options? | American News

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An option is a contract between two parties that guarantees the buyer of the option the right, but does not bind him, to buy or sell a quantity of an underlying asset at a specific price within a specified time. determined.

The value of an options contract is tied to the price of its underlying asset, such as an individual stock or a stock index. There are also options on futures, bonds, currencies, interest rates, and exchange-traded funds. Like stocks and bonds, options are a type of security. Since options derive their value from another asset, options are also classified as derivatives.

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Call options grant the buyer the right to buy a specific amount of an underlying asset, and put options grant the buyer the right to sell the underlying asset. For stock options, each option contract typically represents 100 shares of the underlying stock.

The strike price of a contract is the price at which the transaction of the underlying asset will take place if the right of the buyer of the contract to buy those shares is exercised. Each option contract also has an expiration date. If the option is not exercised at the end of the expiration date, the contract expires and is no longer valid.

Call option contracts where the underlying asset is currently valued above the strike price and put option contracts where the underlying asset is currently valued below the strike price. Exercise rights are considered “in the money” because they can currently be exercised for profit. Call option contracts where the underlying asset is currently valued below the strike price and put option contracts where the underlying asset is currently valued above the strike price. exercise are considered “out of the money”. Call and put option contracts where the underlying asset trades at the strike price are considered “at the money”.

In return for the flexibility that option contracts provide the buyer, option prices include the additional cost of a time value premium. The farther in the future the expiration date is, the higher an option’s premium will be. As the expiration date approaches, the time premium decreases, a process known as time value decay.

A trader who buys an option contract has three choices. The trader can choose to exercise the contract at any time before the expiration date and buy or sell the underlying asset. The trader can also keep the contract until it expires. On the expiration date, out-of-the-money option contracts and at-the-money option contracts expire worthless, while in-the-money contracts are generally automatically exercised.

However, many options traders simply sell their contracts and close their positions before their expiration date without ever buying or selling the underlying asset.

A long-duration buy strategy is an alternative to buying shares of an underlying stock or other asset. Due to the availability of leveraged option contracts, a trader can make a bullish bet on a stock at a fraction of the original cost by buying call options instead of buying the underlying stock . However, this inherent leverage means that call option contracts are generally much more volatile and riskier than their underlying stock.

A bullish call spread involves buying out-of-the-money call options for a stock and then simultaneously selling the same number of call options at a higher strike price. A bullish buy spread is a way for investors to speculate on a moderate rise in an underlying asset while lowering the net premium cost of the trade.

A long straddle is a way for options traders to bet on a large movement in the price of an underlying asset in either direction. To build a long straddle, a trader simply buys both calls and puts at the same strike price, usually close to the current market price of the underlying asset.

A long squeeze is the simultaneous purchase of out-of-the-money buy contracts and sell contracts. The hope is that the price of the underlying asset will move so much one way or the other that the profitable half of the trade will more than offset the losses on the losing side.

Although options trading is generally considered highly speculative, options can also play an important role in a long-term investment portfolio. The married put option trading strategy is a common way for long-term investors to hedge against a stock market crash. By tying a small number of out-of-the-money put options to their major stocks, investors can essentially buy insurance policies that only pay out in the event of a severe market downturn.

Another way investors can use options to potentially improve their long-term returns is to write covered calls. Investors who already hold a large long-term equity portfolio can generate additional income from that portfolio by writing out-of-the-money call options against their underlying stocks.

As long as the price of the underlying stock or other asset remains below the strike price of the call option contracts, the seller keeps both the underlying shares of the stock and the call buyer’s option premium. If the asset price rises above the strike price, the call option seller is obligated to sell the underlying stock to the call option buyer. However, the call seller can still keep the premium from the sale and they can simply redeem their original stake in the stock at any time.

Options offer several advantages over stock trading. The leverage effect inherent in options contracts makes them profitable. It takes a lot more money up front to buy an interest in a stock than to establish an equal sized options position. Options often generate a much higher return than the underlying stock or other asset if the price of the underlying asset moves in the right direction. Options can also be used by long-term investors to hedge or mitigate risk in their portfolios or even to generate additional income from their investments.

The options market is not as liquid as the stock market and bid-ask spreads can be significant. A wide spread means that there is a big difference between the price a buyer has to pay for an option contract and the price he will receive when selling it. Options also suffer from time value decay, also known as theta decay. As the expiration date approaches, the time value assigned to this contract continues to lose value. Finally, options contracts can be extremely volatile and risky relative to their underlying assets. Stock prices rarely reach $0, but it is common for option contracts to expire completely worthless, resulting in a 100% loss for buyers.

Options contracts date back to the writings of Aristotle around 350 BC. Aristotle described the philosopher and astrologer Thales paying olive press owners an initial bounty for the right, but not the obligation, to use their olive presses during the olive harvest season. When that year brought a large olive harvest, Thales was then able to sell its right to the olive presses for a huge profit.

Option contracts also played a role in the famous tulip bulb bubble of the 1630s in Holland, during which speculators entered into basic call contracts with tulip bulb planters that gave them the right to buy mature bulbs at a specific price at a later date.

FAQs

When an option contract is exercised, the holder executes the contract and buys or sells the underlying stock or other asset at the strike price.

US options contracts can be exercised any time before the expiration date, but European options contracts can only be executed on the expiration date.

No, unexercised stock options do not pay dividends, even if the underlying stock does.

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