Options are another asset class, just like stocks, ETFs, and even commodities are asset classes. While they can be riskier than some investments, such as blue-chip stocks, they also offer advantages that other asset classes can’t.
One way to think about options is as a bet between traders about how a security or asset class will move in the future. These securities are also known as “derivatives” because they derive their value from the underlying asset.
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:
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.
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.
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.
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