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What are options and how do you trade them? A detailed explanation


Definition of an Option

An option is a contract that allows you to buy or sell a unit of the underlying asset in the future at a fixed price. Options come in call and put varieties.

Option is a contract
Option is a contract

Example of an option

Let's take a closer look. Suppose that the current value of a company's stock is one hundred dollars per share. The buyer enters into a contract that grants the right to buy the asset at one hundred dollars per share for a limited period of time.

This type of contract is called a call option and the set price in the option contract is called the strike price. For the purpose of this example, we will say that the cost of this contract is two dollars. In other words, this is the price of the option.

Let's look at three possible scenarios.

Call option – Scenario 1.

The share price increases to 120 dollars in the given time period. In this case, the buyer can exercise the option to buy shares at one hundred dollars. And immediately sell them for 120 dollars earning twenty dollars minus the two dollars that were paid for the option for a total profit of eighteen dollars. This is 900 percent of the 2 dollar investment.

Call option - successful scenario
Call option – successful scenario

Call option – Scenario. 2.

If the share price drops for instance to 80 dollars, it isn't profitable to use the option and buy shares for 100 dollars. So the option runs out and the buyer loses the two dollars invested in the option.

Loss is limited
Loss is limited

Call option – Scenario 3.

If the share price increases to 102 two dollars, the income will be two dollars which covers the amount paid for the option. This share price beyond which the trader will make a profit is called the break-even level for the purchased option.

Break-even
Break-even

A put option works the same way but in the opposite direction. With a put option the option holder has the right to sell shares at a predetermined price.

In the example above where the share price drops with a put option the trader can buy the stock at eighty dollars and sell for 100 hundred dollars as set in the option contract. Thus making a profit.

Put option - successful scenario
Put option – successful scenario

Exercising option before expiration

A special feature of classic options is that you don't have to wait for the expiration time in order to exercise the option. For example. A trader bought a put option for the same two dollars.

And an hour later the asset price fell to eighty dollars. The trader can sell the option whenever he wants in order to make a profit.

Exercising option before expiration
Exercising option before expiration

The strike price of an option

The fixed price for buying or selling shares under a contract is called the strike price. In our previous example. The strike price was 100 dollars for a call option. The higher the strike prices compared to the current share price the cheaper the option.

This is because the price is less likely to reach a higher strike price although the potential profit is greater.

Call option
Call option

Now consider a call option in which the strike price is below the current share price. Options with strikes like these are called in the money options. Since you are already making a profit. But the cost of such options is much higher and the profit percentage is lower.

In-the-money call option
In-the-money call option

For a put option everything works exactly the opposite. The higher the strike price is compared to the current share price the more expensive the option. The lower the strike price the cheaper the option.

Put option
Put option

Expiration time

The expiration time is the deadline for using the right to buy call or sell put the asset at a fixed price the strike price. The expiration usually falls at the end of the workweek.

This means for example that you can buy an option for the end of the current week or the following week or for the last week of the selected month.

Options expiration
Options expiration

The farther the expiration is from the current date the more likely the price of the asset will move in the direction the buyer wants so the more expensive the option. The cost of options is determined by the market. IQ Option uses 13 options exchanges.

Cost of an option
Cost of an option

Market conditions depend on a combination of many factors: supply and demand among traders, price volatility in the past, time to expiration and more.

We wish you successful trading on the IQ Option platform.

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Bart Bregman

Fulltime Day trading, and help Iq option wiki in my spare time to build an awesome platform to help beginners out there. #digital nomad, traveling all over the world.

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