Options Trading
1. Definition
Options Trading involves contracts that grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) on or before a certain date (expiration date). Unlike futures, where the contract must be fulfilled, options allow the holder to let the contract expire worthless if it is not profitable.
2. Basic Types
2.1. Call Option (Right to Buy)
Purchased when the trader expects the asset price to rise. * Example: The right to buy Apple stock at $150 next month. If the stock hits $200, you still buy at $150.
2.2. Put Option (Right to Sell)
Purchased when the trader expects the asset price to fall. It acts as insurance against price drops. * Example: The right to sell Apple stock at $150 next month. If the stock crashes to $100, you can still sell at $150.
3. Components
3.1. Strike Price
The predetermined price at which the underlying asset can be bought or sold.
3.2. Premium
The market price of the option contract itself. The buyer pays the premium to the seller to acquire the right. This represents the buyer's maximum potential loss.
3.3. Expiration Date
The date on which the option contract becomes void.
4. Buyer vs. Seller Payoff
| Role | Option Buyer (Holder) | Option Seller (Writer) |
|---|---|---|
| Position | Long (Has the Right) | Short (Has the Obligation) |
| Profit | Potentially Unlimited | Limited to the Premium received |
| Loss | Limited to the Premium paid | Potentially Unlimited |
| Analogy | Insurance Policyholder | Insurance Company |
5. Risks
5.1. Time Decay (Theta)
Options are "wasting assets." As the expiration date approaches, the value of the option erodes, primarily due to the decreasing probability of the option becoming profitable. Traders can lose money even if the asset price stays flat.
5.2. Unlimited Risk for Sellers
Writing (selling) options carries significant risk. While they collect the premium upfront, if the market moves drastically against them, they are obligated to fulfill the contract, leading to potentially unlimited financial losses.