How does trading in stock options work
What are options? How do options work?
It is understandable if you consider trading options "dangerous".
But, is this really the truth?
We think your attitude will change as you learn more about this investment product. Because options are often used to minimize risks.
You too can limit your own risks with the help of options. However, basic knowledge about this product is essential.
What are options and how exactly do they work?
After reading this article you will know the most important terms, understand the difference between call and put options and what 'going long' or 'going short' means.
Topics discussed in this article:
- important terms
- Call options and put options
- Long & Short
A. Important terms:
What are options?
An option is a derivative and gives the buyer the right to sell or buy a specific product at a predefined price at a specific point in time. The value of an option depends mainly on the price of the underlying asset, the term of the options contract and the volatility.
What is a call option?
A call option is a financial product that gives the buyer the right to buy an underlying asset, e.g. a share, at a pre-defined price (exercise price). In addition, the date on or up to which the right can be exercised (the so-called expiry date) is also specified. The amount for which the option is traded is called the option premium.
What is a put option?
A put option is a financial product that gives the buyer the right to sell an underlying asset, e.g. a share, at a predetermined price. The date on which or until which the right can be exercised is also specified (expiry date). The value for which the option is traded is called the option premium.
What is the underlying asset of an option?
The underlying asset is the investment product (e.g. a certain share, an index, currencies or a certain commodity) on which the price of a derivative is based. Well-known examples of derivatives with an underlying asset are options, futures and leverage products.
What is the expiration date of an option?
The expiry date indicates when a financial product, such as an option or a future, expires. The standard expiration date is the third Friday of the month of expiration. However, the German and American options exchanges also have different expiration dates, e.g. for daily options and weekly options.
What is the strike price of an option?
The strike price of an option is the price at which the holder of an option can sell or buy the underlying asset. After the option period has expired, the option holder determines whether he will exercise his right to buy or sell at the exercise price.
B. Trading Call and Put Options
When trading options, there are two types of options available: call options and put options. A purchased call option with a share as an underlying gives the owner the right to buy shares at a predetermined price (the strike price) on or until the option's expiration date. The investor pays an option premium for this right.
The seller of the call option receives the premium and, when exercising the option, has the obligation to sell shares at the exercise price. Selling an option is also called 'writing an option'.
The opposite is true for the right of a put option. A bought put option with a share as an underlying gives the owner the right to sell shares at the strike price on the expiry date. With a written put option, you can be required by the buyer of that option to buy shares at the strike price.
|to buy||Sell / write|
|CALL||Right to buy stocks||Duty to sell stocks|
|PUT||Right to sell stocks||Duty to buy stocks|
An investor who has a call option exercises his right to buy shares only if the price of the underlying asset is above the exercise price on the expiry date.
If the price is below the strike price, the buyer of the call option can buy the shares directly on the stock exchange at a lower price. Please note: the buyer of the call option has the right to exercise the option, not the obligation. The seller, however, has a duty to sell the shares as soon as the buyer of the option exercises it.
The opposite is true for put options. The investor only exercises his option if the price of the underlying asset is below the exercise price. In this case, the investor can sell his shares from exercising the option at a higher price than the current price traded on the stock exchange. Here the seller of the option is obliged to buy the shares when the option is exercised.
|Act of the buyer||Seller's duty|
|Price higher than the exercise price||The buyer exercises the call option||The seller is obliged to sell shares at the exercise price|
|Price lower than the strike price||The buyer does not exercise the call option||No|
|Act of the buyer||Seller's duty|
|Price lower than exercise price||The buyer exercises the put option||The seller is obliged to buy shares at the exercise price|
|Price higher than the exercise price||The buyer does not exercise the put option||No|
The exchanges make new options available for trading on a monthly basis. For liquid stocks, there are standard options with a term of 1, 2, 3, 6 and 12 months
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