For those who don’t know what options are, let’s go over the basics. An option is a contract that gives you the right but not obligation to buy/sell assets at a price on or before a specific date. Some assets that people buy and sell through trading options are stocks, currencies, commodities and indices (such as the FTSE).
Options are considered ‘derivatives’; their value is derived from something else –the underlying asset – so they will fluctuate based on how this underlying performs (get more info here).
Two types of options: calls and puts
When you buy a call option, this gives you the right to BUY an underlying asset at a price before a set date. Let’s say you bought Apple shares at $100 in January, and now it’s June, and they’re currently trading at $120.
You can then buy (call) an option to purchase Apple shares for $115 by the end of the month. If they are trading above your strike price until the end of July, let’s say at $150, this means that you’ll be able to sell them for a profit. However, if they drop below your strike, let’s say down to $95, this means that you’ll have lost out on the upside.
What does buying a call option mean?
If you decide to purchase a put option, this gives you the right to SELL an asset at today’s price before a set date. Again using our Apple example from before, let’s say that you did not own any shares but wanted some protection against the downside risk.
You could then buy a put option which would enable you to sell your shares for $100 by the end of June – making you some money in today’s market. If they’re trading above $100 by then, let’s say at $120, this means that buying this put will allow you to sell them for a profit. However, if they drop below $100 by the end of June (for example, down to $80), this means that you would make money even though Apple’s share price has dropped.
What does it mean to buy a put option?
Now you know what an option is and how calls and puts work, let’s dive into why new traders should start with buying options rather than stocks or forex trades.
The main benefit for beginners comes from the leverage that options trading offers. It is because you can control the exact size of assets without having thousands of dollars sitting in your account. Let’s go back to our Apple example; instead of needing $120,000 to buy 100 shares at $120, you only need $500 to buy an option for 100 shares at $115. The potential profit and loss is precisely the same as if you made the trade in the share market but with a much smaller outlay of cash.
You can see this as a bit strange as it doesn’t make sense why the cost would be so much less than buying them directly. However, one thing to note is that, unlike stocks which give you ownership of assets, options give you rights – therefore needs to be priced accordingly.
You also need to take into account that your risk is limited to only paying what your options cost; for example, if Apple dropped below $100 by the end of June and was trading at $80 – there’s no way you could lose more than the $500 you put down to buy this option.
You can’t lose more than your investment
Most beginners prefer trading calls over puts as it’s less risky. It is because if shares rise above your strike price by the end of the given date, they will keep on rising and generating profits. Alternatively, if they drop, even though you have lost out on earnings, you have not lost any more money.