As defined by the Financial Industry Regulatory Authority (FINRA), Options are a contract bought or sold between two parties that provides an individual with the right but not an obligation to buy or sell a particular asset at a specific price within a determined time frame.
When investors purchase options, they have to be aware of several factors, such as the risk involved and how they affect their possible profit. Although there is no guarantee for profit when buying and selling stocks, buying and selling options can lead to high profits and losses depending on whether the option is in-the-money, out-of-money, or at-the-money.
Out-of-money means that the option’s strike price is higher than the current stock price and in-the-money means that the option’s strike price is lower or equal to the current stock price.
When struck at the money, options have no intrinsic value as their strike prices match the market prices of stocks. In this particular case, both buyer and seller share profits from stock without taking any risk. If struck out of money, buyers will need to pay more on premium than what they can potentially earn if it’s in the money.
When it comes to call options, if they are struck in the money, the buyer could exercise them and buy stocks at a lower price, leading to high profits. If struck out of money, buying call options is not worth it.
Experienced investors should always familiarize themselves with all details about an option before trading one, especially when dealing with short-term contracts, which are less likely to have enough time for strategies to play out. Twenty-day expirations tend to offer traders more flexibility and increased liquidity while still requiring limited commitment.
Long-dated options offer the least liquidity and the highest margin requirements: For example, monthly options have increased liquidity, therefore more time for strategies to play out. However, their margin requirements are also higher than other expirations.
Every option consists of two parts: The option buyer and the Options Seller. The buyer gives the seller a contract with several terms that must be followed to close the transaction within its term. If either party meets the conditions of the contract, then they will abide by them once closing takes place. If not, both parties suffer financially due to the lack of completion of said agreement.
Listed options’ specifications provide broad language and procedures for all market participants, which declare:
- An underlying asset: is any equity security, stock market index, commodity, government debt security, foreign currency, or other financial instruments related to an option. The ‘contract size’ or ‘unit of trading’ of the underlying asset covered by a contract is referred to as its ‘contract size’ or ‘unit of trading.’ Settlement of the underlying asset might be done by delivery of the underlying asset or payment in cash from option profits. All equity options are physical deliveries, whereas index options are cash-settled.
- The right to buy (a call) or sell (a put) the underlying security at a specified price is known as an option. The choice to exercise the rights of an option is called ‘an exercise.’ An option holder is the one who holds the rights to an option. The writer of options contracts is referred to as ‘the option seller.’
- The strike price or exercise price of an option is when the option holder may trade the underlying security to execute their option.
- A premium is an amount paid by the buyer of an option to the writer for the writer to fulfil the contract terms if the holder exercises them.
- The expiration date is when the options contract becomes null and worthless, at which point the option holder loses their rights to the option.
- When an option is exercisable, it’s determined by its style.
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