Options Trading TipsOptions are contracts that allow investors to either buy or sell a particular underlying asset at a specific price within a set period of time. Trading options can give investors an opportunity to make very large gains. However, options do decay in price over time, so it is important to understand how to property trade these vehicles correctly and to be mindful of their expiration dates.
Investors pay money for options because they believe that the price of the underlying asset is either going up or going down. When the price of the asset rises, call options will also rise in value. Conversely, when the price of the underlying asset goes down, then a call option will also decrease in value.
When an investor purchases a call option on a stock for example, they actually buy in lots of 100 shares of the underlying stock. Therefore, if the price of the option for ABC stock is $1, then the call option on ABC stock will cost the investor $100 for one contract that gives him or her the right – but not the obligation – to purchase 100 shares of ABC stock at a specific price known as the strike price. Thus, the strike price for a call option is the price at which the investor would be able to purchase the actual shares of the underlying stock.
A put is essentially the opposite of a call. When an investor purchases a put, they are betting that the price of the underlying asset is going down. Therefore, when the strike price of a put goes up, then the put option will increase. This is because the investor will have the right to make the seller – or writer – of the put purchase the underlying stock at a higher price.
Something that investors must keep in mind with both calls and puts is that options do not last for an indefinite period of time. All options have expiration dates. And, as the expiration date draws closer, the option will begin to lose value. In fact, one of the most common mistakes that investors make with options is holding on to them for too long. When this happens, oftentimes the option will expire worthless. Therefore, in some cases it is better to trade the option prior to its expiration and recoup at least some of the initial investment.
Many investors never actually exercise the options that they purchase. Instead, these investors simply trade the options themselves. A nice amount of profit can be generated when trading options directly without ever buying or selling the underlying asset.
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