Options come in two main varieties: calls and puts.
- Calls give you the right, but not the obligation, to buy a market at a set price before a set date
- Puts give you the right, but not the obligation, to sell a market at a set price before a set date
Buy a call option, and you’ll get a long position on its underlying market. The more the market’s price rises, the more profit you can make. Buy a put option, and you have a short position on the underlying market. The further the market drops, the more profit you can make. Once either option expires, it will become completely worthless.
Here’s how to calculate the profit or loss on an options trade:
Profit or loss = underlying market’s price – strike price – premium
Profit or loss = strike price – underlying market’s price – premium
Options can seem complicated at first because of the terminology used by traders. Here’s a rundown of some of the key terms involved in options, and what they mean:
- Writers and holders: the buyer of an option is known as the holder, while the seller is known as the writer. In a call, the holder has the right to buy the underlying market from the writer. In a put, the holder has the right to sell the underlying market to the writer
- Premium: the fee paid by the holder to the writer for the option
- Strike price: the price at which the holder can buy (calls) or sell (puts) the underlying market
- Expiration date: the date on which the options contract terminates. After the expiration date, the option is worthless – so if the underlying market doesn’t hit the strike price before the expiration date, the holder can’t earn a profit
- In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), meaning the holder can exercise the option and trade at a better price than the current market price
- Out of the money: when the underlying market’s price is below the strike (for a call) or above the strike (for a put), meaning that exercising the option will incur a loss on the trade
- At the money: when the underlying market’s price is equal to the strike, or very close to being equal to the strike
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