Unlike other securities, options feature a collection of unique functionalities. An options contract provides the trader the opportunity to open leveraged bullish or bearish positions in a variety of markets. If done correctly, buying and selling options contracts can be lucrative, producing consistently positive returns.
However, before diving into the market with both feet, you need to understand a few options basics. Read on to learn options essentials and get some tips on when you should buy or sell an options contract.
An Options Primer
An options contract is a legally binding agreement between a buyer and seller that outlines the terms of a forthcoming exchange. It is defined by the underlying asset, its price (strike price), quantity, function (call or put), directive (buy or sell), and expiration date.
Here is a brief look at each component of an options contract:
- Expiration date: The forthcoming point in time when the contract is settled.
- Strike price: The price at which the underlying asset is to be bought or sold at expiration. Strike prices are considered to be at the money (ATM), in the money (ITM), or out of the money (OTM).
- Quantity: The amount of the underlying asset pledged to the contract.
- Calls and puts: A call option gives the holder the right to purchase an asset at strike on some forthcoming date in time. A put option gives the holder the right to sell an asset at strike on some forthcoming date in time.
- Buying and selling: When traders buy a call or put, they pay a premium for the contract. When traders sell a call or put, they collect a premium for guaranteeing execution of the contract.
Knowing When to Buy or Sell Options
There are huge differences between puts and calls as well as buying and selling options. To illustrate the functionality of each, assume that Jerry is looking for opportunities in September corn options. After a bit of study, it is apparent that price is unlikely to stay at the current ATM level of 545’0. Here are Jerry’s possible courses of action:
- Buy calls: September corn calls with a 545’0 strike are priced at 18’5 per bushel. A premium of $925 (5000 * $0.185) is paid for one September corn call.
- Buy puts: September corn puts with a 545’0 strike are priced at 11’5 per bushel. A premium of $575 (5000 bushels * $0.115) is paid for one September corn put.
- Sell calls: A September corn call at 545’0 may be sold for the $925 premium. The premium is collected up front.
- Sell puts: A September corn put at 545’0 may be sold for the $575 premium. The premium is collected up front.
As you can see, buying calls and puts gives Jerry direct bullish or bearish market exposure. The only risk is the premium. If the call closes ITM (above strike), Jerry realizes a profit; if the put closes ITM (below strike), Jerry earns a profit.
In contrast to buying calls and puts, selling options contracts is a completely different ball game. Although Jerry gains initial revenue from the premiums, actual profits depend on the calls and puts expiring OTM. This exposes Jerry to potentially unlimited liabilities if corn rallies (calls) or falls (puts) unexpectedly.
So how does a trader know when to buy or sell an options contract? Here are three instances when becoming active in the options markets may be a good idea:
In some cases, market fundamentals, technicals, and expertise suggest the development of forthcoming pricing trends. When a strong case can be made for a directional move in asset pricing, a trader can buy puts or calls to secure direct bullish or bearish market exposure.
Time decay, or theta, is the rate at which an option contract’s value declines over time. Generally, the further out the contract expiry, the slower the time decay; the nearer the expiry, the faster the decay. If you’re interested in buying and selling options, then time decay is a key factor determining when to engage a specific contract.
When it comes to the financial markets, pricing volatility offers both risk and reward to active traders. Options are no different. Periods of enhanced volatility create pricing inefficiencies, which can create opportunities or undermine existing strategies. During exceptional volatility, buying and selling options offer countless ways of speculating for profit as well as hedging risk.
Interested in Learning More About Buying and Selling Options?
At first, the functionality of options can be confusing. However, by engaging in some due diligence, anybody can become comfortable buying and selling options contracts.
To learn more, contact the options pros at Daniels Trading. With decades of experience, the team at Daniels Trading has everything you need to get up and running trading options in no time.