What is Option Trading | Option Trading Strategies for Beginners

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What is Option Trading?

What is Option Trading?

Options trading is the trading of options in the stock exchange at a price that is relatively less than the stock price. Before understanding options trading we need to understand what is an “option” in the field of the stock market. An option is simply right given to the investor that lets them either purchase or sell underlying assets at a price called strike price. As options are the rights given to the investors, it is not considered an obligation because you can exercise your right or you may just trade it with other investors. 

The price per option is very less and you have to exercise those options within the specified time period generally considered as the expiration period. After the expiration period, the value of the option is zero and you cannot exercise your options or trade them with other investors.

Types of Options:

The major options that we will discuss in this article are “Call” and “Put” options. Both types of options are very popular in the field of normal stocks, ETFs, mutual funds, or SPACs. Investors are actively investing in both “call” and “put” options as they provide a certain level of benefits if you know how to play with them.

Call Options:

“Call” options give the investors the right but not the obligation to purchase (buy) shares (underlying stocks) at a specific strike price within the given period of time. These call options are termed warrants in the case of Special Purpose Acquisition Company (SPACs). If invested well, call options trading provides very high revenue and is a shortcut method of becoming rich fast. But like every benefit, it comes at a risk.

Let’s take an example to generalize call option trading. Suppose, there is a stock trading at a market price of $10. Also, their corresponding call options are trading at $3, which gives you the right to buy the stocks at a strike price of $11.50. 

Before the expiration period of the call option, suppose the stock price reaches $20 then you can purchase shares at a price of $11.50 costing a total of 11.50+3 = $14.50. This will give you a profit of $5.50 for every share you purchase. If you had purchased a total of 100 call options, you could have bought 100 shares at $11.50 each, even if the market price is $20. The main advantage of buying call options is that they give you more market coverage with relatively low investment. But this advantage also becomes volatile to actual stocks as it starts diluting the share outstanding.

Talking about the risk, if you do not exercise your call option before the expiration period, you could lose all the money that you invested in the call option as they will provide you no value. Another event that might happen is “Gamma Squeeze”. Due to call option trading between market makers and normal investors, the price of stocks starts to rise very rapidly causing the market makers to start buying the stocks of that company to hedge their losses. 

As a result, the price per stock skyrockets and if you are intelligent enough you might get a very high profit in such scenarios. But if you want to hold your call options at that time it might be very risky because if the gamma squeeze stops and starts falling, the price of the underlying call option will fall very rapidly. 

Put Options:

Put Options can be considered as just the opposite of the Call Options. A Put option gives you the right to sell a share at a strike price within the given period of time. You can understand it as insurance for your stocks. Put options give you protection from losing the value of your stock below a certain level so that you will not have to bear huge losses.

Let’s take an example to understand this. Suppose you have 1000 stocks of any company that you purchased at a price of $20 each. With this, your total investment becomes $20,000. This is a huge investment and you don’t want to lose your investment by a huge margin. What you can do is purchase put options at a price relatively less than the stock price, let’s say $2. Now for 1000 stocks, you will have to invest $2000 for put options to sell those stocks at a strike price of let’s say $18 per share. Now, if the market crashes and the stock price reaches below $10 then you can exercise your put options and sell your stocks at $18 with minimal loss. 

In short, put options give you the security to your stocks so that you won’t be in huge loss but if the stocks never went below $18 then you can trade them with other investors to get your investment back. Also if you do not exercise them before the expiration period then they are of no use. One thing that you should have in mind is that you have to pay extra to buy put options meaning you are purchasing the stocks at a premium price. 

Option Trading Strategies:

Long Call:

This strategy can be applied if you know that the stock will rise marginally before the expiration of the call option. If so, you can be profited by a huge capital. 

Suppose you have bought 100 call options at a price of $2 each that lets you purchase a stock at $22 and currently the market is trading at $20. If in the long run, the stock price goes up and reaches $30 before the expiration of the call option, you can exercise your call option and purchase the stocks at $22 costing a total of 22+2 = $24 per share. You will be profited by $6 per share.

But if the stock price is still around the $20 to $24 range then there is no meaning in exercising your call option. So what you can do is, instead of redemption you can trade your call option before the expiration period so that the loss due to premium purchase would be minimal.

Covered/Short Call:

The covered call is a little bit tricky. Unlike long call options where you are buying the call option, in a covered call, you are selling the call option. In covered call trading, you will have an equal number of stocks as you want to sell call options. i.e. if you want to sell 100 call options, then you need to have 100 shares of that company.

Let’s understand this with an example. Suppose you have 100 shares of a company trading at $20, and you believe that the stock price won’t trade higher than $20 or a little higher than that then you can write a contract of a call option for it. i.e. you wrote a contract for a call option, that gives the buyer the right to buy your 100 shares at a price of $21 within the expiration period of 4 months. With this contract, you can now sell 100 call options at $1 each giving you a profit of $100. 

From the above example, it is clear that you as a trader got a profit of $100 by selling call options that you created for your 100 shares. Now if the stock price never passed $21 within 4 months periods then the buyer of your call options will not exercise them and you will have your 100 shares with you plus the $100 that you profited by selling the call option. 

If the stock raised and surpassed $21 then the buyer will exercise his call options and buy your 100 shares at a price of $21, giving you a total profit of $100 only. So with this strategy, you will only have a maximum of $100 i.e. the premium that you sold your call option. But talking about the loss, if the stock price goes down below $19, then the buyer won’t exercise his call option and you will lose your money.

Long Put:

The long put lets the investor sell their stock at a strike price within the specified period of time. For example, if you have 100 stocks of a company that is trading at $20 right now. You are thinking of holding your stocks for a while, but if you believe that the stock might go down then you can purchase put options to hedge your losses. Let’s say the put options are trading at $1 each which lets you sell your stocks at $20, so you will purchase 100 put options at a price of $100 for an expiration period of 4 months.

Now if the stock price goes down suppose $15 per share before the expiration period, you can exercise your put options and sell your shares at a price of $20 with a loss of only $100 that you used to buy the put options. 

But if the stock price never goes down to $20 then you will never exercise your put options and you will bear a loss of $100 but it is minimal as you are getting profit due to the stock price rise above $20.

Short Put:

This is similar to short call options in the case of put option trading. In this strategy, the trader will create a contract saying that he will purchase the share at a strike price and will sell it at a certain cost to earn money. 

Suppose, the stock is trading at $20 and you believe that the stock price will not go below $20 then you can create a put option contract which will give the right to investors to sell their stocks to you at a price of $20. You set this contract as $1 for each put option and an expiration period of 4 months.

Now if an investor buys 100 put options from your contract, you will be profited by $100 which is the maximum you will profit. Because if the stock price rises above the strike price, the investor will not exercise his put options. But if the stock price goes below $20 before expiration, the investor will exercise his put options and will sell his stocks to you at a price of $20 each. This might lead to a huge loss for you if the stock price is very low (below $19). 

The maximum profit you might get from a short put is equal to the premium the investor is able to pay you. In the above example, it is $100. But the maximum loss is as high as $2000-$100 as for the above example where $100 will be the money that you collected by selling the put options.

Final words:

Options trading is very active in the market as investors with very high intelligence of what they are doing are profited by thousands of dollars from it. But before investing in any of the options, you need to be sure of what you are doing with them and should do a proper analysis of the companies that you’re purchasing the stocks or options of. SPACrun is one of the popular analytics tools that you might use if you are trying to invest in SPACs stocks and options. Other than that, it also provides real-time alerts via SMS and emails if there is any de-spac news, stock news, or ticker news so that you won’t miss any updates. Signup to SPACrun now and get your free trial.

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