In the complex world of financial trading, using options as a versatile and strategic investment tool is gaining increasing prominence. Options, essentially contracts that provide the right with no obligation to trade, buy or sell a security at a set price during a specific timeframe, are leveraged in a myriad of strategies by retail and institutional investors. This article delves into the intricacies of two primary types of options: call and put options.
Call options explained
A call option allows an investor in the UK to purchase an underlying asset, such as stocks, at a set price (strike price) on or before the option’s expiration date. This option is typically used when an investor expects the underlying asset’s value to increase, allowing them to buy it at a lower price and make a profit.
Critical components of call options
- Strike price: The predetermined price for the underlying asset at which it can be bought.
- Expiration date: The trader must exercise the option, or it will expire worthlessly.
- Premium: The price an investor pays to purchase a call option.
- In-the-money (ITM): When the underlying asset’s current market price is higher than the strike price, making the call option profitable if exercised.
- Out-of-the-money (OTM): When the underlying asset’s current market price is lower than the strike price, rendering the call option worthless if exercised.
An investor can either hold onto a call option until it expires or sell it before expiration to realise any profits. However, if an investor chooses to exercise the call option, they must have enough funds to purchase the underlying asset at the correct strike price.
Put options explained
On the other hand, a put option gives an investor in the UK the right to trade, buy or sell an asset at an agreed price. This option is typically used when an investor expects the underlying asset’s value to decrease in the future, allowing them to trade it at a higher price and make a profit.
Critical components of put options
- Strike price: The predetermined price for the underlying asset at which it can be sold.
- Expiration date: The option may be exercised or will expire worthless.
- Premium: The price an investor pays to purchase a put option.
- In-the-money (ITM): When the underlying asset’s current market price is the same or lower than the strike price, the put option is profitable if exercised.
- Out-of-the-money (OTM): When the underlying asset’s current market price is the same or higher than the strike price, the put option is rendered worthless if exercised.
Similarly, to call options, an investor can hold onto a put option until expiration or sell it before the end. If an investor decides to exercise the put option, they must have enough of the underlying asset to sell at the strike price.
Critical differences between call and put options
While both options involve a buyer paying a premium for the right to trade, buy or sell an underlying asset, some crucial distinctions remain between them. Call options are used when an investor expects the underlying asset’s value to increase, while put options are used when they anticipate it to decrease.
With call options, an investor’s potential profit is unlimited, while their possible loss is limited to the premium paid for the option. Conversely, with put options, an investor’s potential profit is limited to the difference between the underlying asset’s current market price and the strike price.
In contrast, their possible loss is limited to the premium paid. Options have an expiration date, and as they approach this date, their value decreases due to time decay. However, this effect is more pronounced in call options than put options.
Call options typically require a lower upfront cost, making them more accessible for retail investors. In contrast, put options usually have a higher premium, making them less appealing to retail investors. Call options benefit from increased volatility, while put options perform better during market decline or increased uncertainty.
Strategies involving call and put options
Here are some common strategies used by investors with call and put options:
An investor in the UK holds a long position in an asset and trades call options on that asset. This strategy may generate additional income if the underlying asset’s price remains relatively constant. Investors can keep collecting premiums from selling call options without selling their assets.
Like a covered call, an investor holds a long position in an asset and buys options on that asset as protection against potential losses. If the asset’s price decreases, the put option will increase in value, offsetting some or all losses incurred by holding the underlying asset.
The benefits of using an options broker when trading call and put options
Trading options can be complex, and it is essential to have a thorough understanding of the underlying asset and various strategies. Therefore, working with a reputable broker like Saxo Bank can offer several benefits. Brokers often provide their clients with market research, analysis, and other tools to help them make informed decisions.
Brokers have expertise in options trading and can help investors navigate the various strategies available, considering their investment goals and risk tolerance. They also have access to advanced trading platforms that allow for quick execution of trades.
Investing in options can be a lucrative but complex strategy. Understanding the basics of call-and-put options is crucial for investors looking to incorporate them into their portfolios. Knowing the different components, critical differences, and shared strategies involving these options can help investors make informed decisions and manage risk effectively. As with any investment, thorough research and careful consideration are crucial to success in trading call and put options.