There is no assurance of profits in trading. There may be a lot of precautionary measures and strategies to make, but there is still no guarantee to totally eliminate the risk of losing. Recently, we have talked about some hedging techniques to lower investment risks. We have tackled hedging through derivatives, which involves the use of put options. But what are put options? In this article, we would expand our knowledge about put and call options.
An option is a form of a derivative. A derivative is a security which price is dependent upon another asset. An option is a contract, or a provision of a contract, that gives the holder the right, but not the obligation, to make a specific transaction with the issuer according to a certain condition agreed upon the contract. However, this contract comes with a certain fee that is multiplied with the number of assets it would cover. This price is called a premium.
A put option entitles the holder the right, but not the obligation, to sell an asset at a specified price which is also known as the strike price. On the other hand, the seller of the put option is obligated to buy the stock at the agreed price. A put option can be used any time before its expiration date.
An investor buys a put option because he speculates that his stocks will fall at a later date. In order to secure his profits, he buys a contract that locks in the price of his assets so when the time comes that his stocks drop in price, he can still sell them at the specified price.
The seller of the put option is obligated to buy the assets at the specified price if the contract is used before its expiration date. However, if the contract hits its maturity date and the buyer do not use it, the seller gets to keep the premium paid for the options.
A call option grants the holder the right, but not the obligation to purchase an asset at a specified price for a certain period of time. If the stock price does not meet the strike price within the duration of its validity, then the contract becomes worthless.
An investor buys a call option if he predicts that a stock will increase in value. Once the strike price is hit, he has the option to purchase the stocks at any time within the duration of the contract at the specified price.
As with the seller of put options, the seller of the call options is obligated to sell the assets to the buyer at the strike price once the contract is used. But if the contract expires before the buyer uses it, the seller gets to keep the premium paid for it.
Understanding the gains and risks
The relationship between the seller and the buyer of options is like a zero-sum game. Only one will gain while the other loses. The only difference is the limit of the gains and risks they are exposed to. The buyer of the options can only lose the maximum amount of the premium he paid for the contract, while the seller can lose the whole amount of the strike price multiplied to the number of assets involved in the contract.
Conversely, the buyer of the options can secure his profits, even when the market is falling, or maximize his possible gains when the market increases since he can buy at a lower cost. On the other hand, the maximum gain that the seller can get is only the premium paid for the contract.
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