Options trading can be a great way to generate extra income or to protect your investments. However, it can also be risky if you don’t know what you are doing.
Today, we will cover everything about it: the benefits and risks, how options contracts work, and how to calculate profits and losses.
Table of contents
- What are options contracts and how do they work?
- How to calculate profits and losses on options trades
- The benefits of options trading
- The risks of options trading
What are options contracts and how do they work?
Options contracts are agreements between two parties that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain timeframe. There are two types of options: call options and put options.
A call option gives the holder the right to purchase the underlying asset, while a put option gives the holder the right to sell the underlying asset. The price at which the underlying asset can be bought or sold is known as the strike price, and the time frame in which the option can be exercised is known as the expiration date.
Investors typically use options contracts as a way to hedge against future price movements in assets such as stocks, bonds, and commodities.
How to calculate profits and losses on options trades
Options are a type of derivative, which means they derive their value from an underlying asset. The most common underlying asset for options is stock, but options can also be based on commodities, currencies, and more which are traded on exchanges and over-the-counter markets.
To calculate your profit or loss on an options trade, you need to know three things:
- The option’s strike price;
- The premium you paid for the option;
- The underlying asset’s price at expiration.
The strike price is the price at which you have the right to buy or sell the underlying asset.
The premium is the amount you paid for the option.
The underlying asset’s price at expiration is its price when the option expires. If it’s a call and expiration is greater than or equal to the strike price, then it’s in-the-money and you will exercise your right to buy the underlying asset.
The benefits of options trading
Options trading can be used to speculate and offer potential rewards. For instance, options contracts can be used to generate income through premiums, or to protect against losses in other investments.
In addition, options allow investors to trade with leverage, which can magnify both gains and losses. As such, options trading can be attractive for those looking to diversify their portfolios and take on additional risk.
The risks of options trading
Options also come with certain risks. For example, if the underlying asset doesn’t move in the expected direction, the option may expire worthless.
In addition, options are often complex financial instruments, and it can be difficult for individual investors to understand all of the risks involved.
As a result, options trading is not suitable for everyone. Before trading options, it is important to understand the risks involved and to consult with a qualified professional trader.