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What are Options and How Do They Work?

Options trading has become increasingly popular for the younger generation of investors who want to maximize potential returns on relatively smaller capital investments. But as much as options can increase gains, these derivative products can amplify potential losses when executed poorly. Here is a beginner-friendly guide on what options are and how they work.

What Is It?

As the growing finance platform SoFi Invest defines it, options are contracts representing an underlying asset, such as company stock. The contract gives the holder the option to buy or sell the underlying asset for a predetermined price, also called the strike price. Note that options contracts give you the right but not an obligation to exercise the contract before or at the expiration date.

An options contract usually represents 100 shares of the underlying asset. Different types of options exist, such as stock or ETF options. The financial derivative is further subdivided into two main types – calls and puts.

Calls Versus Puts

Call options mean you are bullish on the underlying asset that the options contract represents. You are essentially buying the right to buy the asset at the strike price at expiration. Call options essentially have capped returns on investment but are also less risky since you do not own any assets outright. Thus, when the price of the stock or ETF plunges, you simply let the contract expire rather than exercise your right or your “option.”

Puts are the exact opposite in that it gives the contract holder the “option” to sell the underlying asset at the strike price at expiration. A buyer of a put contract pays a premium outright and is protected against financial losses in the event that the underlying asset’s value drops.

As you explore the market further, you’ll encounter what’s known as a put-call ratio. The term refers to the number of call options that are being actively traded in the market relative to puts. You can use the ratio to determine overall consumer sentiment towards the company stock.

How Do You Trade Options?

Now that you have a better understanding of the financial derivative, let’s dive into how to trade options. The equity options market is open between the hours of 9:30 AM to 4 PM eastern standard time from Monday to Friday. The market for future options, on the other hand, is open 24/7.

There are different ways you can trade options, one of which is to sell contracts to generate income through premiums. Selling put options when market conditions are generally less volatile can net you some premiums for the contracts that are not exercised by holders.

Covered calls are another common strategy for trading options. An investor will write and sell a call options contract and, concurrently, purchase the underlying asset. Selling the contract generates profits upfront to the underwriter of the covered call contract. This type of trade is often assumed by an investor if he/she believes that there isn’t much upside left in the underlying asset they are currently holding.

As per the experts at SoFi Invest, “Options are derivative contracts that give the right, but not the obligation, to buy or sell an asset, making them a potentially useful tool if investors want to trade or hedge their portfolios.” Options can seem complex, with different ways to trade them and a whole set of terminology used in the market. Having said that, options trading can also protect your investment portfolio if implemented correctly.

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