What are options and how can you make money trading them. This is a question with many parts. First, let’s tackle what an option is. An option is a financial derivative that represents a contract sold by one party, the option writer, to another party, the option holder. This contract offers the option buyer the right, but not the obligation, to purchase or sell a security or other financial instrument at an agreed on price during a certain period of time or on a specific date. Because of all the variables inherent in options, these instruments are extremely versatile financial instruments that can either make the buyer extremely rich or extremely poor.
How Are Options Used
Traders in these securities many times use them as speculation vehicles even though this practice is relatively risky. On the other hand, many traders who like to hedge their bets use options to help reduce the risk of holding onto an asset too long. As far as their use as a speculation tool, it is obvious that option buyers and option writers have mutually conflicting views regarding the outlook on the performance of the options underlying security.
What Is A “Call” Option
There are two types of options, the call, and the put. We’ll take the call option first. A call option, or simply stated, a “call” gives the buyer of the call the right to buy an agreed amount of a particular commodity when the “call” option matures. As an example, let’s say that on January 1 you bought a gold option at $80.00 an ounce and the call option ran six months until June 1. Your call option also gave you the right to buy 1000 ounces of gold at the strike price of $80.00 an ounce. When June 1 rolls around the price of gold has risen drastically to $150.00 and ounce. You then call in your option and buy 1000 ounces of gold at $80.00 an ounce. Because the market price of gold has risen dramatically you have just made $70,000.00 dollars. But who is obligated to buy the gold at $150.00 and ounce? The writer of the call option. But of course, it could also go the other way too. If gold dropped $20.00 an ounce to $60.00 you would have lost -$20,000.00.
What Is A “Put” Option
A put option, on the other hand, gives the owner of the “put” the right to sell the underlying asset at a specified price when the “put” matures. We will use our same gold example here to give you an idea of the puts workings. Let’s assume you bought your gold put option on January 1 when the price of gold was $80.00 an ounce. Your put option will run 6 months until June 1. When June 1 rolls around the price of gold has dropped to $30.00 an ounce. You call in your put option and sell 1000 ounces of $80.00 and ounce gold for $30.00 an ounce and take home $50,000.00. Who is obligated to buy the asset at an over the market price? The party that wrote the put option. But of course, it could also go the other way too. Instead of dropping, the price could increase too. Who loses in that transactions? Generally the buyer of the option.
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