Options trading is a financial strategy that allows investors to buy or sell assets at predetermined prices within specific time frames. This tutorial will explain the fundamentals of options trading.
A call option gives the holder the right, but not the obligation, to buy an asset at a specific price called the strike price before or on a specific date. It's profitable when the asset price rises above the strike price. In this example, the strike price is 50. The call option only becomes profitable when the stock price exceeds 50.
A put option gives the holder the right, but not the obligation, to sell an asset at a specific price called the strike price before or on a specific date. It's profitable when the asset price falls below the strike price. In this example, the strike price is 50. The put option only becomes profitable when the stock price drops below 50.
Payoff diagrams show the profit or loss of an option at expiration based on the underlying asset's price. They help visualize potential outcomes of options strategies before making investment decisions. For a call option, profit increases as the stock price rises above the breakeven point. For a put option, profit increases as the stock price falls below the breakeven point.
Let's look at a practical example of a call option. You buy a call option for a stock currently trading at 50 dollars with a strike price of 55 dollars for a premium of 3 dollars. What happens at expiration? If the stock price is below 55 dollars at expiration, the option expires worthless and you lose your 3 dollar premium. This is your maximum loss. If the stock price is above 55 dollars, you start making profit. Your breakeven point is at 58 dollars, where you recover your 3 dollar premium.
Now let's examine a put option example. You buy a put option for a stock currently trading at 50 dollars with a strike price of 45 dollars for a premium of 2 dollars. What happens at expiration? If the stock price is above 45 dollars at expiration, the option expires worthless and you lose your 2 dollar premium. This is your maximum loss. If the stock price is below 45 dollars, you start making profit. Your breakeven point is at 43 dollars, where you recover your 2 dollar premium.
Several factors affect option prices. The underlying asset price is a primary factor. The strike price determines the option's intrinsic value. Time to expiration affects the option's time value. Volatility measures the uncertainty of price movements. Interest rates impact the cost of carrying positions. Dividends can affect the underlying asset's price.
Options offer limited risk for buyers. The maximum loss is the premium paid. However, sellers face unlimited risk with limited profit potential. Proper position sizing and stop-losses are essential for risk management. In this diagram, we see how buyer risk is capped while seller risk can be unlimited.