Friday, June 8, 2012

Basic trading for stock Options Finance

Derivatives are quite new financial instrument that requires some knowledge before trading it, indeed derivatives (options, futures, forwards) can result in big profit or big loss if you don't know how it work.
Derivatives are financial products that derive the value from an underlying asset ( this asset can be stocks, currencies, commodities, etc...),
Options are part of the derivatives financial instruments, there are 2 types of options:
-Call option: gives the buyer the Right (not the obligation) to buy the underlying asset at a certain date and at a certain price
-Put option: gives the holder the Right to sell the underlying asset at a certain date and price.

The price in the contract is the Strike price or the Exercise price, moreover the one who is buying the right has to pay what we call "Premium" which is the fee for purchasing an option.
At the difference of other financial instruments, you can enter 4 positions with Options:
1)Long call -> Buy the right to buy
2)Short call-> Sell the right to buy
3)Long put -> Buy the right to sell
4)Short put -> Sell the right to sell

Examples: lets say that the Premium is $10 and the strike price $100 to make it simple.

1)Long call: someone who believes a stock price will increase will Long call an option (he buys the right to buy), so as I said before he will pay the premium of $10 dollars and if the price at the specified time is above the strike price of $100 he will exercise his right to buy, on the other hand if the price is less than $100 he won't do anything and his loss will be only the cost of the premium ($10)

2)Short call: someone who believes a stock price will decrease can enter a short call position, he sells the right to buy and receive a premium, if the stock decreases he will keep the premium as profit, but if the stock increases and the buyer decide to exercise the options, then he must sell the stock and he will loose money,
Warning: if you enter a short call option, your potential loss are illimited

3)Long put: someone who believes that the price will decrease can also enter a Long put option,  he buys the right to sell (not the obligation), he will pay the premium, if the price drops under the strike price of $100 he will exercise his right to sell and buy at the spot price and sell a the strike price of $100. On the other hand if the price increases over $100 he will not exercised his option and loose only the premium

4)Short put: someone who believes the price of a stock will increase, will enter a short put option, he will sell the right to sell and receive the premium, if the stock goes up he will keep the premium as a profit, but if it goes down he will have the obligation to buy the stock and will make a loss.

Additional informations:
There are 2 major types of options:
-American option: you can exercise at anytime during the life of the option
-European option: you can exercise only at maturity of the option


Anonymous said...

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