Call and put options are derivative products that give the option holder the entitlement, but not the responsibility, to buy or sell an underlying asset at an agreed-upon time and price. Traders use them for risk management, speculation, hedging and income production. This article will discuss what traders need to know about call and put options, how they work and how they can be used as part of an effective options trading strategy.
- 1 What are call options?
- 2 What are put options?
- 3 How can traders use call and put options?
- 4 How to trade call and put options
- 5 Options trading risks
What are call options?
A call option gives the buyer the entitlement to purchase a specific quantity of an underlying asset at a set price within a specified timeframe, known as the expiry date. The buyer pays a premium upfront for the options contract, representing their maximum potential loss. The options contract then grants the buyer the entitlement to buy the underlying asset at a predetermined price, known as the strike price.
What are put options?
Put options work similarly to call options but give the buyer the entitlement to sell an underlying asset instead of buying it. A put option gives its holder the entitlement, but not necessarily the obligation, to sell a specific quantity of an underlying asset at a set price within a specified timeframe. The premium is paid upfront and represents the maximum potential loss for buying those particular puts.
How can traders use call and put options?
Traders can use call and put options for hedging positions or speculation. Buying calls allows traders to gain exposure to markets without committing all the capital of an outright purchase. Similarly, buying puts allows traders to enter bearish positions with less risk than trading the underlying asset outright. Traders can also use call and put options for income production by selling out-of-the-money calls or puts. It involves collecting the premium from a trader buying a call or put option and closing out the position after it has expired worthless. Traders can use this as an alternative to dividend-paying stocks as a source of income generation.
How to trade call and put options
Decide which asset to trade
The first step in trading call or put options is to decide which asset to focus on. Traders should research their chosen asset and choose one that fits their trading strategy and risk appetite.
Choose a strike price
Once an underlying asset has been chosen, traders need to decide at what strike price the option will be bought or sold. This decision needs to be made based on the trader’s view of whether the underlying asset will rise or fall within the expiry date of the option contract.
Decide how long until the expiry
Traders need to decide how much time they want their options contracts to last before they expire. Different brokers offer different expiration dates, so traders must check with their chosen broker to see which dates are available.
Choose a call or put option to trade
Traders then decide whether to buy a call or put option depending on whether they expect the underlying asset to rise or fall in price.
Assess potential risks
Traders should assess potential risks associated with trading call and put options. It includes ensuring that the expiry date is suitable for their strategy, understanding the premium and assessing the underlying asset’s volatility. Trading call and put options can be a valuable tool for all traders, but traders must research thoroughly before entering any trades.
Options trading risks
Options contracts have a limited lifespan, and traders must know when their options contract will expire. If the underlying asset moves opposite to what was expected, the option may expire worthlessly, and all the premium paid upfront is lost.
Volatility can cause problems for options traders as large price movements can negatively affect positions held for too long. Traders should check volatility before entering any trades, as this can influence how much time is needed for an option to reach profitability.
Trading options requires a minimum amount of money to be deposited with a broker as collateral, known as margin requirements. It is the maximum amount of money a trader can potentially lose in an options trade. Understanding margin requirements when trading options is essential, as they can significantly affect how much capital is needed to open a position.