When a trader buys an options contract (either a Call or a Put), they have the rights given by the contract, and for these rights, they pay an upfront fee to the trader selling the options contract. This fee is called the options premium, which varies from one options market to another, and also within the same options market depending upon when the premium is calculated. The option's premium is calculated using three main criteria, which are as follows:
Options trading may seem overwhelming, but they're easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
Just as you can buy a stock because you think the price will go up or short a stock when you think its price is going to drop, an option allows you to bet on which direction you think the price of a stock will go. But instead of buying or shorting the asset outright, when you buy an option you’re buying a contract that allows — but doesn’t obligate — you to do a number of things, including:
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
Commodity futures used by companies give a hedge to the risk of adverse price movements. The goal of hedging is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that hedge use or producing the underlying asset of a futures contract. Examples of commodities hedging use include farmers, oil producers, livestock breeders, manufacturers, and many others.
According to Nasdaq's options trading tips, options are often more resilient to changes (and downturns) in market prices, can help increase income on current and future investments, can often get you better deals on a variety of equities and, perhaps most importantly, can help you capitalize on that equity rising or dropping over time without having to invest in it directly.
The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.
When buying or selling options, the investor or trader has the right to exercise that option at any point up until the expiration date - so simply buying or selling an option doesn't mean you actually have to exercise it at the buy/sell point. Because of this system, options are considered derivative securities - which means their price is derived from something else (in this case, from the value of assets like the market, securities or other underlying instruments). For this reason, options are often considered less risky than stocks (if used correctly).