Options are known to add value to your investment portfolio. It is a type of derivative security wherein the contract offers the right, but not the obligation, to sell or purchase a security at a set price (also known as strike price) on or before a particular date (also known as exercise date).
There are two types of options in the derivatives market, namely, call options and put options. A call option is an agreement between two parties wherein the buyer gets the right, but not the obligation to purchase the underlying securities in the future. A put option is just the opposite of a call option. In a put option, the purchaser is given the right, but not the obligation to sell the underlying shares or index in the future.
It is important to understand how an investor makes a profit in options trading. In order to earn profits through options, it is necessary to be either an options buyer or an options seller (also known as options writer). Many have the preconceived notion that an investor may profit from options only if the market is facing high volatility. However, the same is not necessarily true. You may trade options during periods of low volatility and earn good profits.
Mechanism of profits in options trading
If you are an options buyer, you may earn profits if the underlying asset, say a commodity, increases above the strike price for a call or reduces below the strike price for a put. This rise or fall should occur before the options contract expires.
Similarly, an options writer may earn profits if the underlying asset, say a stock, stays below the set price if the call option is written or stays above the set price if a put option has been written. Again, this occurrence must take place before the expiration of the contract.
It is easy to determine the exact amount of profit that you may make while trading in options. You may take the following two aspects into consideration while identifying your returns.
- The difference between the stock price and the option strike price when the option position has been closed or during expiration.
- The premium amount collected by the options seller or the premium paid by the options buyer.
Options are an excellent form of derivatives for hedging and speculating. You may trade in options to hedge an open position or to speculate if there is a price movement in the value of the underlying asset. Alternatively, you may also trade in future contracts to limit the risk exposure involved in the trade. You may, therefore, trade in futures and options,and protect your trading positions from making a loss.