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Most investors’ portfolios consist of several asset classes like stocks, bonds, ETFs, or mutual funds. But options are assets that, if deployed correctly, can cause your portfolio to surge like stocks and ETFs can not, especially in time with high volatility. However, trading options can be challenging, especially for beginners. But if beginners understand it through options trading examples, the concepts can be simplified and anyone can become a successful option trader.
Want to learn how to start trading options? Read this article further for some basic and easy-to-understand option trading examples.
2023 Beginners Guide to Options Trading With Options Trading Example
What Are Options?
An option contract is a form of derivative instrument that gives the buyer the absolute right but not the obligation to buy or sell an underlying asset at a specific chosen price known as the “strike price” or “exercise price” at a future point in time known as the expiry date. These instruments are classified as “call-option” and “put-option” contracts; buyers must pay a premium to sellers to obtain any of them.
Call options contracts provide the right to buy the underlying asset at the predetermined strike price. In the case of put options, a right to sell the underlying asset at a predetermined strike price is provided. The buyers have the liberty to exercise these options any time before the expiration date if the market price is favorable for them. Otherwise, these are rendered worthless. This ensures the potential losses are limited to the amount of premium paid.
However, call-and-put writers must buy or sell if the option expires in the money. Sellers must fulfill the promise to buy or sell and thus are exposed to unlimited risks.
Options Trading Example
Call and Put options are usually used to obtain a hedge against rising and falling price levels. For instance, if Mr. Robert has invested $1,000 to purchase 100 shares of XYZ limited and believes the price of these shares will increase to $20, he can hedge against the risk of a decline in those shares by purchasing a put option. Intrinsic value of the options are the price each share is worth at the time of expiry.
Each options contract would represent 100 shares of XYZ limited, having a strike price of $10 and valued at $2. Now, if the price of XYZ limited shares increases to $22, the Put option will be rendered worthless, but the buyer’s loss will be limited to $200, i.e., to the extent of the total premium paid. Further, if its price decreases, say to $5, the option will be exercised, and the buyer’s net gain will be $300. (100 shares * (10-5-2))
Contrary to that, if Mr. Robert believes the price of the shares of XYZ limited will decline to $5, he can hedge against the risk of an increment in those shares by purchasing a call option at an exercise price of $20. In this situation, if the price declines to $5, Mr. Robert’s loss will only be limited to $200, i.e., the amount of premium paid. Moreover, as there is no upper limit on XYZ stock price, Mr. Robert will have massive profit potential.
Hopefully, the example above gave you a basic understanding of this strategy.
How to Trade Options?
There is a wide range of options strategies, from simple ones to complicated approaches. Traders can employ these strategies to wager on fluctuating price levels. Below are some of the most basic options strategies with respective options examples.
1. Long Calls
Long Calls are one of the most basic options trading strategies a trader employs when he is reasonably sure that the price of an asset will increase in the near term, also known as a bullish bet. The difference between covered calls and naked calls is the level of downside risk with naked calls being riskier.
Say an options trader has bought a contract with 100 call options on a stock of XYZ limited, which is currently trading at $10 by paying a premium of $2. His investment will total up to $200, and he will be able to recover his costs as and when the price of a stock of XYZ limited reaches at least $12. The stock’s gain will be more profitable for him because a $1 increase in the price of a stock will double his gains as each option is worth $2. If the opposite happens, the options will expire, but the trader’s loss will be limited to $200.
2. Long Puts
Just like Long Calls, in a Long Put, the trader bets on the fact that the price of the underlying asset will decline.
Suppose a trader purchases a put option representing the right to sell 100 shares at $10. The stock price is $20. He pays a $ 2 premium for that right, taking his investment to $200. He will be able to recover his cost if the cost of the shares drops to $8 ($10 strike price -$2 premium); however, profits are still capped as the price cannot drop beyond 0. The maximum loss is also limited to the premium amount paid.
When a trader buys a Call and a Put option with the same strike and expiration date at the same time, it is called a straddle. This strategy is suitable when the underlying price rises or falls dramatically.
Say, if a trader believes the price of a stock will increase dramatically from its current price of $50, one put and one call at the $50 strike price, each having the same expiry date. The total cost of creating the straddle will be $100, and if both these Calls and Puts trade at $2 premium outlay will be $4. Now, the stock has to rise or fall by at least 8% to earn a profit for the trader to remain in a favorable position. This options trading example has made the Straddle strategy easy to understand.
If the trader buys and sells multiple options (both puts and calls) of the same type and on the same asset, he is said to create a spread strategy. Although similar, these options vary regarding strike price and expiry date. This can be related to the term or option strategies of “selling options”. +
Say there is a stock trading at $140, which a trader feels could rise to $150. So, he can buy a call option at a premium of $9.3, having an exercise price of $135, and sells a call at a premium of $2.5 with a strike price of $150. Thus, his aggregate premium outlay comes at $6.8 ($9.3-2.5), and the spread between both at expiry is $15 (150-135). Now, if the market gains beyond $150, the maximum profit potential will be $8.20 ($15-$6.8), while if it falls below $135, the options will expire, and the maximum loss would be limited to $6.8 ($9.3-$2.5).
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