Many traders are aware of the capacity of equity options to generate large sums of income in the market. Novice traders, or those unfamiliar with options, though are perhaps unaware of how they work and what methods are available for using them for profit. This article will attempt to inform option newcomers and clear up the enigma of equity options.
Equity options are derivative financial instruments that are quite popular. While derivatives may have a bad reputation as of late, equity options are long-respected and fairly accessible tools that many traders use to hedge and minimize risk. Generally speaking, equity options are simply based on stock—the innocuous matter found on the DOW Jones. In this way, options are really not that foreign. An option trader, though, must understand how derivatives and stocks are different. Stocks change in value and are traded as assets for their current price. Equity options are different because they derive their value from the value of the underlying stock, index or ETF.
A call option is frequently used to illustrate how equity options function. With a call, a buyer purchases the option from the seller and thus secures the right, but not the obligation, to acquire the underlying asset at a specific strike price.
Consider the following scenario. You have a call option which is in essence an agreement with another party. The writer (seller) is agreeing to sell you 100 shares of XYZ at $4/share at any time before the expiration date (Saturday following the third Friday of the month). You and the seller both lock in this agreement (contract) so you don’t have to worry about the opposite party simply reneging.
Now, if the XYZ price/shares plummet to say $2, it would be unwise to exercise the option and pay $4 per share. That’s what is interesting about options: you have no obligation to exercise. If, on the other hand, the market value skyrockets to $6, exercising suddenly seems like an incredibly viable route. Upon exercise, you could buy $6 shares for only $4. The trick is to make a profit through leverage and wise investment.
But how does the other side stand to make a profit if no obligation exists? The buyer pays a premium for the option, which acts as the investment principal. Due to the premium you have to pay, both sides of the trade have a potential reward.
Thus, equity options offer buyers the potential opportunity acquire assets at great discounts while providing sellers the chance of cashing in on a premium. If responsibly traded, investors can employ an option strategy to produce an overall profit and return on investment.
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