Understanding Option Contracts

What cannot be done with an option

How to Hedge the Iron Condor With a Calendar Spread Call and put options are contracts that are known as derivatives because they derive their values from other securities, contracts or assets.

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Puts and calls provide a flexible way to hedge your investments. Hedging is a strategy in which losses in one position are fully or partially offset by gains in another position.

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You can also use options to speculate on investment ideas at a relatively low cost. You can hedge a call option with a put option once you understand how options work. Tip Put options can hedge call option positions in many ways. Understanding Option Contracts Puts and calls share certain characteristics: Option purchasers hold a long position. Option sellers, also called writers, hold a short position.

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Options trade on public exchanges where a clearinghouse mediates all trades between buyers and sellers. Options have an expiration date when the contract expires. You can buy options that expire in periods ranging from a few minutes to more than a year. Most options have standard weekly and monthly expirations.

February 21, by Mike Butler Don't let assignment cause you anxiety! Some people like to be assigned stock as a part of their strategy i. The 3 most common questions we get asked related to trading options and being assigned stock are: What situations would cause me to get assigned stock? What can I do to prevent being assigned stock? And…If I am assigned, what should I do?

You can exercise an option, which means you can buy or sell the underlying asset. You can exercise American-style options at any time until they expire. You can exercise European-style options only at expiration. Options give purchasers the right, but not the obligation, to buy with a call or sell with a put a fixed quantity of the underlying asset.

For example, an American-style put on XYZ Corp stock gives what cannot be done with an option put buyer the right to sell shares of XYZ at the strike price at any time until expiration. Option traders pay a dynamic price, called a premium, to buy options. Option writers collect premiums for writing options. You can close out an option position at any time until expiration.

The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium. Or they can become totally different products all together with "optionality" embedded in them.

You close out an option by selling the options you bought or buying back the options you wrote at the current market price of the option. Buying Puts and Calls You buy a call or put by paying the premium, which depends on several factors, including: Intrinsic value: This is the relationship between the strike price and the asset price.

Time value: This is the time left until contract expiration. The more time left until expiration, the higher the time value.

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Time values dwindle to zero as expiration approaches. Volatility: Highly volatile underlying assets will cause option writers to demand a higher premium when they sell options, because the options have a greater chance of gaining value. Interest rates: High interest rates cause call premiums to expand, but depress put premiums. The effect is due to the difference in the cost of buying, say, a call on XYZ stock and directly buying shares of the stock. The money saved by purchasing the call instead of the shares can earn interest, so higher interest rates benefit call prices.

The opposite effect occurs with put prices.

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Dividends: When a stock pays a dividend, its share price falls to reflect the distribution of equity to shareholders. Therefore, stock dividends decrease call values because call buyers benefit when stock prices rise.

Conversely, puts gain value because put buyers benefit when the stock price falls. The Role of the Option Writer The option buyer pays an initial premium, and that is the maximum loss the buyer can sustain. The option writer collects the initial premium and then hopes the option will expire worthless.

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If a call buyer exercises an option, the call writer must deliver the underlying asset at the strike price. That means the call writer must either go into the market to buy the shares i. The call writer must absorb the loss or forfeited profit represented by the difference between the asset price and the strike price.

The premium is all-time value, not intrinsic value, because the call what cannot be done with an option price is above the asset price.


Note that the call writer has unlimited risk, since there is no limit on how high the asset price will rise. Had the call writer sold a covered call, the risk, if any, would be limited to the difference between the price the writer originally paid for the shares and the strike price.

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Puts work the same way but in the inverse direction. When a put buyer executes the put, the put writer must buy the underlying asset at the strike price from the put buyer. Put writers can write covered puts by first shorting i.

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Note that the call buyer can simply sell the call for its current market price instead of executing the call. In this case, the original buyer makes more by selling the option than by executing it. Call Option Hedge Calculation You can use a put option to lock in a profit on a call without selling or executing the call right away. Sophisticated Option Hedging There are many hedging strategies involving puts and calls. For example, you could hedge a short call with a long put, in which the premium collected on the short call partially offsets the premium paid for the put and the risk that the call will gain value.

One of the most popular hedging strategies is called a spread.

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There are three basic types of spreads: Horizontal spread: Also called a calendar spread, this Involves offsetting options with the same strike price but with different expiration dates.

They are set up to take advantage of time-value decay. That is, the options with the closer expiration date will lose value faster than sites to earn bitcoin options.

Technically, this is called theta decay.

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In one type of calendar spread, you sell near-term calls or puts and sell longer-term calls or puts. The premium you collect from selling the option reduces your overall cost. Once the near-term option expires, you have a naked put or call, which you hope will gain value before it expires.

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Vertical spread: This spread uses options with the same expiration dates but with different strike prices.

It is typically used to offset the net premium you pay to establish a hedge. Vertical spreads can be bull spreads that profit from rising prices or bear spreads profiting from falling prices. Diagonal spread: This is a combination of a horizontal and vertical spread, with different expiration dates and different strike prices.

Spreads form the basis of even more complicated strategies, such as collars and iron condors. The latter involves purchasing or writing two vertical spreads, one with puts and one with calls. One last spread was invented by a witty trader.