An option is one of the powerful tools that the investors have to be familiar with. The options have been introduced to help the investors in managing and limiting risk. Investors basically use options mainly for two reasons- to hedge risk and to speculate risk. If you don’t have time in your hand to participate actively in trading, this post would be beneficial for you to learn about auto-robots in trading.
Below mentioned are few terms one should be familiar with:
Option buyer- It is the party who buys the contract.
Option seller- It is the party who creates or writes the contract.
Strike price- The option seller agrees to sell or buy the stock in future at a specified price known as the strike price.
Expiration date- Always it is the 3rd Friday in a month, the date at which option contract would expire.
Speculating and hedging risk using options
In case of speculation, you will buy stocks anticipating the stock will move in a particular direction. However, it is always risky as it is quite uncertain in which direction the investment would move. Whenever you buy the options you are limiting the downside risk while the upside potential is unlimited.
In the case of hedging, it helps in protecting your investment from a financial disaster. Hedging is just like purchasing insurance. You purchase them as a way to protect yourself from the unforeseen events. Options also act in a similar way, you pay an extra fee to protect your portfolio from unforeseen risks. For the fear of loss, one would be happy to shell out the extra amount by purchasing options.
Characteristics of options
- Options are a derivative instrument. It means that the prices get derived from another security’s price. More specifically, the price of options is derived from the price of the underlying stock.
- Every option represents the contract between seller and buyer. Seller has the obligation either to sell or buy stock. It depends on what kind of option he is planning to sell (put option or call option) to the buyer for a specified date at the specified price.
- The person who buys the option contract has the right to complete the particular transaction on the specified date but does not have an obligation. Whenever the option contract expires, if the buyers do not wish to exercise the contract, he does not have the obligation to do anything.