The trader must pay the cost of the option ($5.00 x 100 shares = $500). The stick price starts to rise as expected and then stabilizes at $110: before the expiry date on the options contract, the trader can engage in a call option and purchase all the shares of the company's stock at $70, the strike price on the options agreement. The trader pays $7,000 for the stock and can sell the new stock on the market for $11,000, making a profit of $4,000.
Call vs. Put / Seller vs. Buyer
As this paper has already stated, options one the ability, without an obligation, to engage in a security at a set price within a particular time period. With a call option, the buyer has the right, though is not required to buy at a set quantity of a commodity or a financial instrument from a seller by a particular expiration date for a certain price. On the other hand, a put option is the right to sell the underlying stock at a given strike price by a particular date. "The party that sells the option is called the writer of the option. The option holder pays the option writer a fee -- called the option price or premium. In exchange for this fee, the option writer is obligated to fulfill the terms of the contract should the option holder choose to exercise the option" (diffen.com).
When things are more volatile, the call premiums are larger, and are thus better for writing, because one earns more income when the volatility is high (Greg, 2011). With higher prices of options, investors are more fearful: "If someone has to pay a lot of money for an option above its intrinsic value, then the VIX is high. The general rule is that option premiums are high when the VIX is over 30" (Greg, 2011). On the other hand, a good time to purchase a put on a stock that one owns is when one has made a solid gain, but if one's level of certainty isn't that stable regarding the act of cashing out: puts can help in protecting against short-term volatility in long-term holdings (dummies, 2012). In the first example, one's put option helps to act as an insurance policy to help act defensively regarding one's gains. The latter example, if one's put goes up in value, one can sell it, decreasing the paper losses on one's stock: one can ultimately decide which put option to purchase by determining how much profit prospective one is okay with losing if the stock increases (dummies, 2012). Another term which is widely used is the term regarding "selling naked"; this is comparable to buying a call option, as it allows one to accrue more money when the underlying stock increases (dummies, 2012). Thus, this means that one is able to sell the put option without shortness in the stock and in the journey; one is able to hope that the stock stays at the same price or rises which will allow one to maintain the same premium (dummies, 2012).
Things to Consider
However, there are still things to consider when purchasing an options contract: "When you purchase an options contract, you pay a premium for the privilege that goes along with holding that contract; you're not paying for the full value of a stock. For instance, if you wanted to commit some of your investment capital to Google (GOOG), you'd be paying in the neighborhood of $625 a share. Buy 500 shares and that investment is the equivalent of a piece of real estate…" (Moon, 2012). While it's still possible to play the market in this fashion, it's not always the most ideal way as it can sometimes be very expensive. There's still a way to play Google and a range of other sticks with a much smaller initial investment along with a greater likelihood of getting return which can equal and sometimes even exceed what the average investor might experience. Options in this fashion can help to open the door to an even greater variety of equities and ETFs for capitalized investors that might not otherwise be able to have such expensive stocks in their portfolios (Moon, 2012).
Options Contract in the Stock Market
On the other hand, many argue that options contracts are crucial in helping to offer traders the opportunity to weigh their stock positions, allowing for a more leveraged position on a stock while mitigating the entire risk of the full purchase: in a likewise fashion, in real estate, such a contract can empower a buyer to gain a hold of options contracts on a range of parcels before having to execute the purchase on a single one, thus, making sure that the buyer will be able to put them all together before moving forward (IA, 2014).
Options Contract in the House Market
One can argue that when it comes to the house market, option selling is one of the most important customer services and profit endeavors available. When the housing market is creaks to a halt in the slow season, "savvy builders use their design centers to entice prospective home buyers. The community sales person, in anticipation of selling the customer a home, sends them to the design center to preview the exciting option program. The design center becomes a critical component of the customer experience and an essential tool for raising profit" (Gullo, 2014). Thus, options within the housing market often manifest as display, design or selling options. Within the housing market this can also manifest as customization, allowing those who invest to make one of a kind customizations and designs. This can help investor increase the value of their initial investment.
Benefits of Options
Even though there are definitive and concerted risks involved in using options, there are also some pretty specific and marked benefits. Options, when used well, have the ability to help one protect investments against declining market prices, while increasing one's income on current or new investments. Equity can be bought at a lower price, and the benefit from an equity price's rise or fall can be regardless of whether one owns the equity or sells it outright (nasdaq.com).
Another major benefit of options contracts are that they create orderly, efficient and liquid markets with high amounts of flexibility: "Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to seek profits or protection" (Nasdaq.com). This means that equity options give investors the ability to set prices for specific periods of time during which investors can buy or sell 100 shares of a given equity for a premium, which ends up being only a percentage of what one would pay to own the equity outright; this gives option investors the ability to leverage their upper hand while increasing the prospective reward from an equity's price fluctuations (nasdaq.com).
Certain other investments might offer risks without boundaries; options trading offers the clear benefit of a set and defined risk to buyers: an option buyer cannot lose more than the price of the option, which is known as the premium. "Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the option contract are not met by the expiration date. An uncovered option seller (sometimes referred to as the uncovered writer of an option), on the other hand, may face unlimited risk" (nasdaq.com).
Disadvantages of Options Contracts
However, these tools are not with their own marked disadvantage. Options contracts are known for having a markedly lower liquidity: this is a result of the fact that many specific stock options don't actually encounter much volume in their lifespan: thus, given the fact that each stock which proves optionable will have different strike prices and expirations, indicates that the specific option that one possesses might in fact be at a very low volume unless it is one of the most popular stocks or indexes (thinktrade.net). However, small traders won't be bothered by this lower amount of liquidity, if they're just trading low numbers of contracts.
Options contracts are also known for possessing higher spreads as a result of the "…lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade" (thinktrade.net). Options trading also encompasses higher commissions which will cost one more in commission per dollar invested: these commissions could be found to be even higher for spreads where one has to pay commissions for both sides gathered (thinktrade.net).
Options are also exceedingly complicated to beginners and they really do take a long time to understand fully and for achieving mastery. Options trading also possesses a certain amount of time decay: one loses the time value of the options…