Options are traded on side markets to the stock markets. They are financial instruments that can be bought or sold at any time. They act a lot like stock and their market value is strongly tied to the stock they are based on.
Option writer & Holder
Each option have two parties. The option writer who creates the option and get money when he sells it and the options holder that buys the option and have the right to exercise it. The option writer earns money if the option matures outside the money. It is very dangerous to act as a options writer as you can loose large amounts of money if the option matures in the money and the option holder exercise the option. This is especially true after Black swan events that causes large unpredictable market movements. There is no limit to how much money you can lose as a options writer. Most financial institutions require you to have the corresponding stock to allow you to act as a options writer. They will require that you have large assets if you want to create uncovered options. IE if you want to create options for which you do not own the corresponding stocks. I do not recommend that you act as an option writer and the rest of this article will focus on options from the perspective of an option holder.
Call & Put options
There are two types of options, call and put options. The two types are sometimes referred to as buy and sell options. A option give you the right to buy or sell an option for a certain price at a certain point in the future. The option matures outside the money if the market value of the stock is below (call) /above (put) the price that the option lets you buy the stocks for. If the market value on the other hand is above (call) / below (put) the market value when the option matures then the option matures in the money. It is rare that the options are actually exercised in such a way that you buy or sell the shares that the options give you the right to buy/sell. Usually your are simply paid the difference between the exercise price and the market price directly into your account.
Most options can only be exercised at their maturation point but there are some options that can be exercised at any time up until maturation.
Binary options are something completely different then regular options. They are not traded on an open market and can not be sold once they are bought. Binary options are traded against the broker not an 3rd party options writer. Binary options also have a fixed return unlike regular options where the return depends on the valuation of the underlying stock. I do not recommend that you trade binary options.
You can read more about binary options and how they work here.
The benefit of options
Options give you the possibility to earn a lot of money by making small investments. Many options are very volatile and the value gains and loses that occur can often be very large. An options can add several 100 or even 1000 percentage points in value in a single day. Options are a very good way to capitalize on a prediction without having to have the capital to buy the shares themselves. It can also be a very good way to capitalize on when you think that the market is wrong about a particular stock. Lets look at an example.
Stock A is a hyped IT stock. The stock trades at 27.8 and the company is about the present their earnings in one week. The general consensus is that it will be a good report and that the stock will continue to go up. You think that the stock is hyped and overvalued and you think they are going to present a bad report that might burst the reality distortion field surrounding the stock. You decide to buy a put option that give you the right to sell Stock A for USD 20 in two weeks. No one think the stock is going to fall that far so you can buy the options for one cent each. You decide to invest usd 1000 in the stock and buy 100 000 of these put options.
The report is, just like you predicted, worse than the market expected and the stock tumbles. At the end of the day it is traded at USD 17. Each of your options are now worth USD3 and your 1000 investment have turned into 300 000 if you sell the options. You have made a 30 000% on your investment.
This is an extreme example but it shows what a valuable tool options can be.
Important things to remember about options is that:
- It is possible to make money from options trading without ever holding an option until maturation.
- It is possible to make money from an option that end up maturing outside the money since the valuation will fluctuate during the entire maturation.
- TA trading with options can be very profitable since the movements of the underlying stock is leveraged in the option.
- It is possible to make a lot of money with small investment so it is possible to bet on unlikely events and still make a lot of money even if only a fraction of the bets matures in the money.
The risk is limited when you act as a option holder. You know that you can only lose your investment and you can chose to sell your options at any time. The options will retain value until it is clear that they will mature outside the money.