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What Is Options Trading?

Options are part of a group of investments called derivatives. This name comes from the fact that they’re not an asset class themselves, but they are ‘derived’ from other asset classes like stocks.While they can be riskier than some investments, such as blue-chip stocks, they also offer advantages that other asset classes can’t.

Options trading, explained

One way to think about options is as a bet between traders about how a security or asset class will move in the future. 

Options investments comes in the form of options contracts. A call option gives the buyer (or holder) the right, but not the obligation, to buy a security at a set price on or before a set date. On the other hand, a put option gives the holder the right to sell a security.

Typically, stock options represent 100 shares of the underlying stock. However, options contracts can be written on any asset class, including currencies and commodities.

Unlike other “advanced” investments, you can purchase options through a traditional brokerage account. However, most brokers will remind you that options carry a significant risk of financial loss, as they are speculative in nature.

There are four critical components to every options contract:

  • The contract is the position of the contract (either a put or a call)
  • An asset is the underlying security driving profits and losses
  • The expiration date is when the contract expires
  • A strike price is the cost of trading the underlying asset on the expiration date

Additionally, there are two parties to every options contract. The buyer, or holder, can choose to either call or put the security of interest. But they are not required to exercise the contract ever, which limits their investment risk.

On the other hand, sellers, or writers, are obligated to exercise the contract if the option expires in-the-money. Because they may have the obligation to move on the contract, sellers are exposed to potentially unlimited risk. Thus, they can lose much more than the initial premium.

Typically, holders take their profits by trading out (closing) their position. In this scenario, a holder sells their position, while the writer buys It back.

Traders can accept one of two types of options contracts. Short-term contracts expire in one year or less. Long-term contracts have expiration dates of one year or more. These are legally classified as long-term equity anticipation securities, or LEAPS.

When the expiration date rolls around, if the contract has not been exercised already, there are two ways to resolve the option. A physical settlement involves buying or selling the underlying asset at the set price. While this is uncommon in commodities, it’s more common with stocks and ETFs. However, some traders also take a cash settlement, which involves handing over the value of the assets rather than the securities themselves.

Types of options contracts

There are two main types of options: American and European. (Note that this has nothing to do with their geography; rather, they describe how options are exercised).

With an American option, the rights to buy and sell can be exercised anything between the date of purchase and expiration. However, European options may only be exercised nearer to the expiration date.

Thus, many options listed on indexes are European. And, because the right to exercise early carries some value, American options also have higher premiums than European contracts.

Q.ai says: There are several other types of exotic options, such as binary, knock-in and knock-out, Asian, and Bermudan. However, these are usually for professional traders, as they’re more complex than the options we’ve covered.

What this means for you

Like all securities, options contracts come with their own advantages and risks. Whether or not they’re a good investment for you depends on your goals, financial situation, and investment time horizon, among other factors.

Options Trading Advantages

  • Requires smaller initial investment than purchasing securities outright
  • Limits exposure to risk on current stock positions
  • Protects investors by locking in prices at no obligation
  • Provides the investor time to watch the market move

Options Risks

  • Options trading investors must be approved through a broker, and trades are limited to your assigned trading level
  • It’s difficult to accurately predict even short-term price movements with options trading
  • Investors may take on unlimited losses with options trading
  • Margin requirements can lead to higher trading costs with options trading

Disclosures

Q.ai is the trade name of Quantalytics Holdings, LLC. Q.ai, LLC is a wholly-owned subsidiary of Quantalytics Holdings, LLC ("Quantalytics"). Quantalytics offers automated financial advice tools through Quantalytics Investment Advisors, LLC ("QAI"), an SEC-registered investment advisor. QIA’s investment advisory services are ONLY available only to residents of the United States. Disclosures concerning QIA’s investment advisory services are available on its Form ADV filed with the SEC. The content in this newsletter is for informational purposes only and does not constitute a comprehensive description of Q.ai's investment advisory services.

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