Discover the fundamentals of buying and selling options.
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If gold hits $1325, you can exercise your option and buy it for $1300, $25 less than the current market price.
If gold stays below $1275, then there’s no obligation to buy it for $1300. Though by not trading, you’ll lose the premium you paid for the option.
Options trading was first devised as a hedging tool. Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy an option to sell your stock at a price that’s close to its current level – then if your stock’s price falls, you can exercise your option and limit your losses. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.
Another key use for options is to extend the time you have to decide about whether a trade is worthwhile. Here, instead of buying a market that you aren’t entirely sure about immediately, you buy the option to trade it before a set date in the future. If, further down the line, you decide that you want to buy the market then you can exercise your option. If not, then once again you’ve only lost the premium.
The flexibility of options has also made them a popular tool for speculation. That’s because the prices that options trade at will vary depending on a number factors, including how much time you have left to exercise your right to trade, and the value of the underlying market. An option to buy gold for $1300, for instance, will typically trade at higher price when gold is at $1299 than when it’s at $1200.
Speculators might trade options with no intention of ever exercising them. Instead, they’ll buy an option then sell it on when its premium increases.
For more information on option price movements, see how to trade options.
Options are flexible, but they can also be complicated. Instead of buying a market in the hope that its price will increase, you have to factor in how much its price will increase and when the movement will occur.
The holder of an option can only lose the premium that they’ve paid, but the writer has many more risks to deal with. These can include early exercising if the holder decides to take up their right to buy or sell the underlying market, or a margin call.
The premium you’ll pay to buy an option is dependent on more than just the price of its underlying market – so before you start trading options you’ll need to learn what moves options prices.
A significant part of an option’s value will often come from the remaining time it has before it expires. This value will diminish as it draws closer to expiring, making options extremely time sensitive.
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