Neal Hutchins Lockhart is a business and finance contributor to several online publications. In the following article Neal Hutchins Lockhart discusses the different types of options trading that continue to lure in savvy investors regardless of market conditions.
Witnessing the ups and downs of the New York Stock Exchange is enough to scare many people off investing but, Neal Hutchins Lockhart notes that for those willing to embrace the chaos, they must quickly learn as much as possible. Options trading gives investors the right to buy or sell an asset at a set price but, before they can do so, they must understand the differences between puts and calls.
Options trading isn’t for the faint of heart. It’s usually reserved for long-time investors with an eye for market fluctuations. Since it’s structured entirely around speculation, it’s important to know the risks and potential rewards before investing. Take a moment to learn the basics and then decide whether options trading suits your portfolio; Neal Hutchins Lockhart notes that this article is for educational purposes and not an endorsement of any particular type of stock option trading.
What is Options Trading?
Neal Hutchins Lockhart explains that options trading is the process of buying and selling options contracts. These contracts give the holder the right to buy or sell an asset at a stipulated price on or before a certain date. The contract does not oblige the holder to buy or sell, though. It simply gives them the right to do so.
People trade options for many reasons—some to speculate, meaning they bet on the price of the underlying asset going up or down; others to hedge, meaning they use options to offset the risk of holding other assets. This is quite different from standard stock investments which are the physical purchase of an asset.
Essentially, when you buy a stock, you are buying a piece of a company and becoming a shareholder. When you buy an options contract, you are not buying anything. Neal Hutchins Lockhart notes that you are simply paying for the right to buy or sell an asset at a certain price.
Options Are Derivatives
An options contract is a derivative, which is a type of security with a value that is derived from another asset. In this case, the other asset is the underlying security—the stock, index, or commodity that the option gives you the right to buy or sell.
Neal Hutchins Lockhart says the price of the derivative is influenced by changes in the price of the underlying security. When the underlying security goes up in price, the option will go up as well; when the underlying security goes down in price, the option will go down.
However, the holder of the derivative does not own the underlying security and, therefore, does not have voting rights or any of the other privileges that come with ownership. Therefore, the option holder is solely responsible for buying or selling.
Call Options
Neal Hutchins Lockhart explains that a call option gives the holder the right to buy an asset at a set price on or before a certain date. For example, let’s say you think ABC stock is going to go up in the next month. You could buy a call option that gives you the right to buy 100 shares of ABC stock at $50 per share on or before the end of the month.
Neal Hutchins Lockhart explains that if the stock price goes up to $60 per share, you can exercise your option and buy the stock for $50 per share, then turn around and sell it for the current market price of $60 per share, making a $10 per share profit. If the stock price doesn’t go up, you can let the option expire and you will only be out the cost of the option.
Put Options
Neal Hutchins Lockhart explains that a put option gives the holder the right to sell an asset at a set price on or before a certain date. For example, let’s say you think the price of XYZ stock will go down in the next month. You could buy a put option that gives you the right to sell 100 shares of XYZ stock at $50 per share on or before that date.
If the stock price goes down to $40, you can exercise your option and sell the stock for $50, then buy it back on the open market for $40, making a $10 profit. If the stock price doesn’t go down, you can let the option expire and you will only be out the cost of the option.
Conclusion
Using these two types of options, Neal Hutchins Lockhart explains that investors can regulate their gains and losses by purchasing the right to buy or sell an asset at a particular price point. The option does not require them to buy or sell but it does give them the ability to sell for a higher profit or lower loss.
Most options traders have a keen sense of the market and can predict when the value of an asset rises or falls. Therefore, this style of trading is best left to long-time investors who have experience tracking market trends.
