Expiration Date (Derivatives) What is an 'Expiration Date (Derivatives)' An expiration date in derivatives is the last day that an options or futures contract is valid. When investors buy options, the contracts gives them the right but not the obligation, to buy or sell the assets at a predetermined price, called a strike price, within a given time period, which is on or before the expiration date. If an investor chooses not to exercise that right, the option expires and becomes worthless, and the investor loses the money paid to buy it. BREAKING DOWN 'Expiration Date (Derivatives)' Some options have an automatic exercise provision. These options are automatically exercised if they are in-the-money at the time of expiry. The Options Clearing Corporation (OCC) automatically exercises a call or put option that is at least one cent in-the-money. Expiration and Option Value. In general, the longer a stock has to expiration, the more time it has to reach its strike price, the price at which the option becomes valuable. In fact, time decay is represented by the word theta in option pricing theory. Theta is one of four Greek words used to reference the value drivers on derivatives. The other three 'Greeks' are delta, gamma and vega. All other things equal, the more time an option has until expiration, the more valuable it is. There are two types of derivative products, calls and puts.
Calls give the holder the right, but not the obligation, to buy a stock if it reaches a certain strike price by the expiration date. Puts give the holder the right, but not the obligation, to sell a stock if it reaches a certain strike price by the expiration date. This is why the expiration date is so important to options traders. The concept of time is at the heart of what gives options their value. After the put or call expires, it does not exist. In other words, once the derivative expires the investor does not retain any rights that go along with owning the call or put. The new Firefox. Download Firefox — English (US) Your system may not meet the requirements for Firefox, but you can try one of these versions: Download Firefox — English (US) Your system doesn't meet the requirements to run Firefox. Your system doesn't meet the requirements to run Firefox. Please follow these instructions to install Firefox. Please follow these instructions to install Firefox. The best Firefox ever. Uses 30% less memory than Chrome. Truly Private Browsing with Tracking Protection.
all things Firefox. If you haven’t previously confirmed a subscription to a Mozilla-related newsletter you may have to do so. Please check your inbox or your spam filter for an email from us. Advanced Install Options & Other Platforms. Download Firefox for Windows. Download Firefox for macOS. Download Firefox for Linux. Download Firefox — English (US) Your system may not meet the requirements for Firefox, but you can try one of these versions: Download Firefox — English (US) Your system doesn't meet the requirements to run Firefox. Your system doesn't meet the requirements to run Firefox. Please follow these instructions to install Firefox. Discover how to trade options in a speculative market. Learn the basics and explore potential new opportunities on how to trade options. The options market provides a wide array of choices for the trader. Like many derivatives, options also give you plenty of leverage, allowing you to speculate with less capital. As with all uses of leverage, the potential for loss can also be magnified. Explore the information and resources below to learn how to trade options.
If you have questions along the way, contact a specialist for help. Understanding the Basics. A long option is a contract that gives the buyer the right to buy or sell the underlying security or commodity at a specific date and price. There is no obligation to buy or sell in the contract, but simply the right to &ldquoexercise&rdquo the contract, if the buyer decides to do so. An option that gives you the right to buy is called a &ldquocall,&rdquo whereas a contract that gives you the right to sell is called a "put." Conversely, a short option is a contract that obligates the seller to either buy or sell the underlying security at a specific price, through a specific date. When the buyer of a long option exercises the contract, the seller of a short option is "assigned", and is obligated to act. To make this clearer, let&rsquos use a real world analogy&hellip Let&rsquos say you&rsquore shopping for an antique grandfather clock and find the perfect one at the right price: $3,000. But you won&rsquot have the cash for another three months. You talk to the owner and he agrees to sell it at that price in three months with a specific expiration date, but you have to pay $100 for him to agree to the contract. After three months, you have the money and buy the clock at that price. But maybe it&rsquos discovered that the clock was owned by Theodore Roosevelt, which makes it worth $10,000.
You have the right to exercise your option and buy it for $3,000, netting you a profit of $6,900 (minus transaction costs). On the other hand, let&rsquos say it&rsquos discovered that&rsquos it&rsquos not an antique at all, but a knock-off worth only $500. You&rsquore under no obligation to exercise your option and buy it at $3,000, so you can opt not to buy it at all and simply let the contract expire. Although you&rsquore still out the $100, at least you&rsquore not stuck with a clock worth a fraction of what you paid for it. From the option seller's perspective, in the first scenario he gets the $100, but is later forced to sell the clock at less than true market value. In the second scenario, he keeps the clock, and the $100 you paid in premium. If you understand this concept as it applies to securities and commodities, you can see how advantageous it might be to trade options. For a relatively small amount of capital, you can enter into options contracts that give you the right to buy or sell investments at a set price at a future date, no matter what the price of the underlying security is today. Some things to consider before trading options: Leverage : Control a large investment with a relatively small amount of money. This allows for strong potential returns, but you should be aware that it can also result in significant losses. Flexibility: Options allow you to speculate in the market in a variety of ways, and use a number of creative strategies.
There are a wide variety of option contracts available to trade for many underlying securities, such as stocks, indexes, and even futures contracts. Hedging: If you have an existing position in a commodity or stock, you can use option contracts to lock in unrealized gains or minimize a loss with less initial capital. Setting Up an Account. You can trade and invest in options at TD Ameritrade with several account types. You will also need to apply for, and be approved for, margin and option privileges in your account. Choosing a Trading Platform. With a TD Ameritrade account, you&rsquoll have access to options trading on our web platform, as well as on our two more comprehensive platforms: Trade Architect, and thinkorswim. Trade Architect is ideal for those traders first starting with options. It features fundamental tools, such as P&L charts, option method chain filters, and other tools that can give you ideas and the ability to test your method. The thinkorswim platform is for more advanced options traders. It features elite tools and lets you monitor the options market, plan your method, and implement it in one convenient, easy-to-use, integrated place. Also, if you plan on participating in complex options trades that feature three or four &ldquolegs,&rdquo or sides of a trade, thinkorswim may be right for you. In addition, TD Ameritrade has mobile trading technology, allowing you to not only monitor and manage your options, but trade contracts right from your smartphone, mobile device, or iPad. Developing a Trading method.
Like any type of trading, it&rsquos important to develop and stick to a method that works. Traders tend to build a method based on either technical or fundamental analysis. Technical analysis is focused on statistics generated by market activity, such as past prices, volume, and many other variables. Charting and other similar technologies are used. Fundamental analysis focuses on measuring an investment&rsquos value based on economic, financial, and Federal Reserve data. Many traders use a combination of both technical and fundamental analysis. Whether you use technical or fundamental analysis, or a hybrid of both, there are three core variables that drive options pricing to keep in mind as you develop a method: Price of the underlying security or commodity. Time to expiration. Implied volatility based on market influences and future outlook. With both Trade Architect and thinkorswim, you&rsquoll have tools to help you analyze these variables and more.
You&rsquoll also find plenty of third-party fundamental research and commentary, as well as many idea generation tools. You can even &ldquopaper trade&rdquo and practice your method without risking capital. In addition, you can explore a variety of tools to help you formulate an options trading method that works for you. You can also contact a TD Ameritrade Options Specialist anytime via chat, by phone 866-839-1100 or by email 247. Building Your Skills. Whether you&rsquore new to investing, or an experienced trader exploring options, the skills you need to profit from options trading should be continually developed. You&rsquoll find Trade Architect, is a great way to start. For veteran traders, thinkorswim, has a nearly endless amount of features and capabilities that will help build your knowledge and options trading skills. What Your Financial Services Firm Should Be. See what sets us apart from the rest with our top 6 reasons to choose TD Ameritrade . Compare TD Ameritrade to other leading financial services firms. Best for Long-Term Investing. For five years in a row, we ranked #1 for Long-Term Investing in Barron's 2017 Online Broker Survey. Check the background of TD Ameritrade on FINRA's BrokerCheck.
Trade commission-free for 60 days plus get up to $600* Offer Details. #1 for Long-Term Investing. Market volatility, volume and system availability may delay account access and trade executions. Educational resources are provided for general information purposes only and should not be considered an individualized recommendation or advice. Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options. Past performance of a security or method does not guarantee future results or success. TD Ameritrade, Inc., member FINRA SIPC. This is not an offer or solicitation in any jurisdiction where we are not authorized to do business. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc.
and The Toronto-Dominion Bank. © 2017 TD Ameritrade. 6 Options Expiration Day Traps to Avoid. Take the following steps to avoid any unpleasant surprises. Don&rsquot Fall Victim to These Mistakes. Options expiration. When you sell options, it&rsquos an anticipated event. When you own options, it&rsquos something to dread. At least that&rsquos how most people view expiration day. If you trade options, there are things you must know, and steps you should take, to avoid any unpleasant surprises on the third Friday of each month. (True expiration is the following morning, but for our purposes here, that is just a technicality.
) I&rsquom going to provide you with some pointers for handling options expiration day. Keep reading to make sure you don&rsquot get caught in any of these expiration traps. #1 Avoid a Margin Call Following Expiration. New traders, especially those with small accounts, like the idea of buying options. The problem is that they often don&rsquot understand the rules of the game, and &ldquoforget&rdquo to sell those options prior to expiration. If a trader owns five July 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that&rsquos fine. However, if the investor is not paying attention and the stock closes at $40.02 on expiration Friday, that trader is going to own 500 shares of stock. The options are automatically exercised (unless you specifically tell your broker not to exercise) whenever the option is in the money by one penny or more when the market closes on that third Friday. On Monday morning, along with those shares comes the margin call. Those small account holders did not know they were going to be buying stock, don&rsquot have enough cash to pay for the shares &mdash even with 50% margin &mdash and are forced to sell them. So please don&rsquot forget to sell your long options. If you own any options, don&rsquot even consider exercising. You may not have the margin call problem just described, but did you buy options to make a profit if the stock moved higher? Or did you buy call options so that you could own stock at a later date?
Unless you are adopting a stock and option method (such as writing covered calls), when you buy options, it&rsquos generally most efficient to avoid stock ownership. If you really want to own stock when buying options, you must plan in advance, or you will be throwing money in the trash. For most individual investors, especially inexperienced ones, buying options is not the best way to attain ownership of the shares. If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit. But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date. There are exceptions, but in general, DO NOT exercise options. Sell those options when you no longer want to own them. It does not matter if you have earned a profit or taken a loss, when you no longer want to own the options, sell them. #3 Do Not Fear an Assignment Notice. If you are assigned an exercise notice on an option you sold, that is nothing to fear, assuming you are prepared. By that I mean, as long as the assignment does not result in a margin call. When you sell an option, you must understand the option owner has the right to exercise that option at any time prior to expiration. When that happens, it should be neither a total surprise nor a problem.
When you write a covered call, being assigned guarantees the maximum profit for the trade. Surely that&rsquos good, and not bad. If you sell options with no position in the stock, be certain you can meet any margin calls if you are assigned an exercise notice. Your broker can supply the answer if you cannot figure it out for yourself. But don&rsquot be afraid of this scenario. Being assigned prior to expiration is usually beneficial from a risk-reduction perspective. #4 European Options are Different. Most options are American-style options and all the rules you already know apply to them. However, some options are European style (no, they do not trade only in Europe), and it&rsquos very important to know the differences if you trade these options. Most index options are European style: options on the S&P 500, Nasdaq and the Russell 2000, but not on the S&P 100 Index. (Note: These are index options and not ETF options. Thus, the SPDR S&P 500 (NYSE: SPY), PowerShares QQQ Trust (NASDAQ: QQQQ) and iShares Russell 2000 Index (NYSE: IWM) are all American-style options.) Here are the three main differences: 1. European options cease trading when the market closes Thursday, one day prior to &ldquoregular&rdquo options expiration day.
2. The settlement price is NOT a real world price. The final &ldquosettlement&rdquo price &mdash the price that determines which options are in the money, and by how much &mdash is calculated by using trade data from early in the trading day on Friday. However, the number is not made available until much later. Thus, when you observe an index price early Friday morning, do not believe that the settlement price will be anywhere near that price. So be careful. Often this settlement price is significantly higher or lower than traders suspect it will be &mdash and that results in cries of anguish from anyone still holding positions. It&rsquos safest to exit positions in Europeans options no later than Thursday afternoon. 3. European options settle in cash. That means no shares exchange hands. If you are short an option whose settlement price is in the money, the cash value of that option is removed from your account. If you own such options, the cash value is transferred to your account. It&rsquos equivalent to buying or selling the option at its intrinsic value. Once again, that value is unrelated to Thursday night&rsquos closing price.
#5 Don&rsquot Hold a Position to the Bitter End. It&rsquos not easy to let go when you bought options. You paid a decent premium for those options and now they may have declined down to half that price. That&rsquos not the point. You bought those options for a reason. The only question to answer is this: Does that reason still apply? Do you still anticipate the stock move you had hoped would happen? If there is no good reason to hold, cut your losses and sell out those options before they fade to zero. Is the shoe on the other foot? Did you sell that option, or spreads, at a good price and then see the premium erode and your account balance rise? Is that short position priced near zero? What are you waiting for? Is there enough remaining reward to hold onto the position, and with it, the risk? Let some other hero have those last couple of nickels.
Don&rsquot take big risk unless there&rsquos a big reward. It&rsquos not a good plan to hold those options until expiration, especially when it&rsquos weeks away. #6 Negative Gamma is Not Your Friend. When you are short options, you are short gamma, and most of the time that&rsquos not a problem. You were paid a nice price for the options and are watching those options evaporate at a decent rate. But this is not free money. There is risk that the stock may make a move large enough so that it threatens to move into the money. When you are short options, they come with negative gamma, and it&rsquos the big, bad enemy. When the reward is small, respect this guy and get outta town. Cover those gamma shorts, take you good-sized profit, and don&rsquot bother with the crumbs. Let the gamblers have those.
Article printed from InvestorPlace Media, investorplace. com201206options-expiration-day-mistakes-to-avoid. ©2017 InvestorPlace Media, LLC. More from InvestorPlace. More On InvestorPlace: Financial Market Data powered by FinancialContent Services, Inc. All rights reserved. Nasdaq quotes delayed at least 15 minutes, all others at least 20 minutes. Copyright © 2017 InvestorPlace Media, LLC. All rights reserved. 9201 Corporate Blvd, Rockville, MD 20850. 4 Must Know Options Expiration Day Traps To Avoid. October 14, 2016. It’s options expiration day and time to decide what to do with your current positions, right?
If you sell options , it’s probably an anticipated event. When you buy options , it’s usually something to dread. Either way, there are things you must know, and steps you should take, to avoid any unpleasant surprises on the third Friday of each month. Here are our Top 5 MUST-KNOW traps to avoid during this volatile time and some pointers for handling any crazy positions… #1 Don’t Exercise Your Long Option. You really shouldn’t consider exercising options at expiration – it’s just not worth it unless you are a big “fan” of the stock and company. Unless you bought a call or put so that you could take a longer term position in the stock, you are generally better off closing the option trade than purchasing the shares. In addition, exercising options come with additional broker commission fees that you don’t want or need to pay. #2 European Options Are Different – Watch Out! A majority of the 30,000+ people who frequent this blog daily trade American style options.
However, we do have visitors from various other major countries all over the world. So we wanted to make sure that everyone knew the differences between the American - and European-style options. Most options that you and I will trade are American-style options, and all the rules you already know apply to them. However, some options are European style (and no, they do not trade only in Europe) which have slight variations. Most index options are European style exercising. European style exercising means that you can ONLY exercise that option AT expiration vs. American when you can exercise the option at any time up until expiration. This is JUST for exercising purposes and doesn’t mean you’re “stuck” in a position until expiration. These are index options and not ETF options, I’ll remind you so the SPDR S&P 500 (NYSE: SPY), PowerShares QQQ Trust (NASDAQ: QQQQ) and iShares Russell 2000 Index (NYSE: IWM) are all American-style options. To help you avoid confusion, I think it would be prudent for me to point out a few key differences between American and European-style options: First, the time when trading ceases is different for American and European options. As you possibly know, when you get to the expiration month, American options cease trading on the third Friday, at the close of business. There are exceptions though. For instance, at the calendar quarter, quarterlies cease trading on the last trading day. European index options, on the other hand, stop trading on Thursday, preceding the third Friday of the expiration month.
Take note of this, since that’s a whole day earlier than the American option. Unlike American options, the settlement price for European options isn’t a real world price. Instead, calculations from trade data from Friday’s early trading day are used to determine the final settlement price. Such a settlement price is what determines the options that are in the money. Hence, you should be increasingly careful not to assume that the Friday morning index price reflects the settlement price. For this reason, it would be far safer to exit your position by Thursday afternoon when dealing with European options. Start The FREE Course on "Options Basics" Today: Whether you are a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this course is to help lay the groundwork for your education with some simple, yet important lessons surrounding options. Click here to view all 20 lessons ? #3 Don’t Hold Positions to the Last Minute. Let’s face it. Letting go is the hardest part of trading. Have a look at these two possible scenarios.
You have this losing trade but you still don’t want to give it up because you think you “could” make money at the end of the day. Conversely, you have some money on the table in profits but you think you still stand a chance to make more money before options expiration. Just to let you know, the last couple of days are the worst time to exit trades because of the increased gamma risk. This means that an option’s value will swing faster in both directions during these final days until expiration. As such, profits can evaporate overnight. Let some other guy trade those last couple of pennies in value, praying for the “big move”. Of course, if you’re a net option seller like us, option expiration is a great time! We just let our positions expire worthless and keep the entire premium we collected at expiration as profit. Honestly we should start having expiration day parties! #4 Check Option Open Interest. Most traders do not take their time to check out option open interest .
This is the number of open contracts for both puts and calls in a given month. The theory behind this is that the more “overlap” there is in the strike prices, the more likely the market will tend to trade towards that level at expiration. Since we know that most contracts expire worthless at expiration, it’s safe to assume that the market will move into an area that causes the “most pain” for option buyers. #5 Consider Rolling Your Option Position. Some investors are adamantly convinced that stocks are better than options, simply because options expire. However, that can be easily dealt with by rolling your option position. You shouldn’t fall into the trap, like many other traders, of losing out on your winning streak as time runs out and when the expiration date draws closer. You can still take advantage of your winning position especially if the position looks likely to continue in your favor. Using a technique known as “rolling”, you can lock in your profits in a favorable position and benefit from additional upside. This is something you can actually do even before expiration week, whether the expiration date is five, three, or two months away.
It would certainly be far better to take advantage of it earlier than later. Rolling helps you bank your profits. You can then use your original investment capital to buy another option with a further-away expiration month. In this regard, consider whether you have calls or puts. With calls, “roll up” to a higher strike price especially if the stock keeps rising. In the case of puts, “roll down” to a lower strike price. This is something you can do continually while your stock keeps on running (for calls) or falling (for puts). Using this technique, you’ll be limiting your risks while locking in your profits. Best of all, you’ll also maintain the same-size position. Apparently, this is a benefit unique to options and thus not found with any other security. It’s no wonder options make such attractive investment opportunities. Kirk Du Plessis.
Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D. C., he’s a Full-time Options Trader and Real Estate Investor. He’s been interviewed on dozens of investing websitespodcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters. Okay, at the fear of sounding really silly, open interest is the amount of contracts out there that could be bought or sold? No stupid questions Christine…A common misconception is that open interest is the same thing as volume of options and futures trades. This is not true. Open interest is the total number of options andor futures contracts that are not closed on a particular day and thus left "open" for trading the next day. Hope this helps!! Okay so if I am understanding this correctly volume has nothing to do with open interest? What does it mean when an option has 3300 open interest and 0 volume? Thanks!
that means 3,300 contracts are still open but no volume on the trading day… Oh, sorry I meant Jan not Dec. Then when is a good time to close your position? Hi, #4 what do you mean by “overlap” in the strike prices. Meaning you want to look for areas where there is big open interest and volume on BOTH the call and put side. That area might be where the market things the stock will close at expiration. The theory is that the market will close in an area that causes most options to expires worthless and therefore causes the “max pain”. How to trade options expiration day In June of 2017 we ceased operation at Friday Option Trader and have transitioned all our members to our premiere service, SPX Option Trader. Please visit us at spxoptiontrader. com We have averaged over 50% per trade day trading SPX Weekly Options with only one trade per day. We have a very unique approach in our intraday trading strategies. Each day we do one trade, and we are simply purchasing either a put or a call on the SPX or the SPY weekly options. Our weekly options trading method allows us to make extremely profitable trades with only a single trade per day. We trade highly volatile and highly liquid SPY and SPX weekly options. The market was transformed a few years ago, with the introduction of weekly options.
Over the past year the introduction of Monday and Wednesday expiration has made the weekly options market a gold mine for those who have the knowledge on how to trade effectively. Our approach is unique as we only trade once per day. We are trading SPX and SPY weekly option contracts on the day before and day of expiration, so this is a highly risky and speculative approach. Our approach is not for everyone, it is risky as the option contracts we trade expire either the next day or the day we are trading. So there is always a chance that if a trade is a loser, it will be a 100% loser as it will expire worthless at the close. However, such volatility also means huge returns for our winners, as our model portfolio shows. Often the greater the risk, the greater the potential gain, and that is true with our approach. We recognize that we could potentially lose 100% of our investment in any single trade, as is true with any option purchase. But as our model portfolio shows there is the potential for great rewards with this approach. We trade both In the Money and Out of the Money Put and Call contracts. We day trade SPX and SPY weekly options just before and on the day of expiration. We normally enter the trade within 5 minutes after the opening bell. We discuss what we are planning to do in our one of a kind SPX Daily Outlook that is sent to all our members daily. Our exit times vary based upon market conditions, but we are always out of the trade by the close of the day.
Our members receive our newsletter each morning within minutes after the opening bell. We share the exact SPX and SPY option contract we are trading on that day, with % profit targets and % stops and key level forecasts for both the SPX and SPY. Click here for an example what our SPX Daily Outlook looks like. We also provide the SPX Spread Trader which is perfect for those who want precise entry and exit prices. Click here for an example of the SPX Spread Trader. Our approach requires that a trader is prepared to purchase put and call option contracts and have the ability to respond quickly. We share what we will be doing in the day ahead, and how you respond is up to you. Some seek to mirror our trades, others seek to improve or even develop their own method using ours as a baseline. Some even use our comments and price targets to trade other markets such as binary options. The levels we share each day for the SPX and SPY are an invaluable resource for all day traders. Whatever your approach SPX Option Trader has the potential to change your life with only one trade per day, day trading SPY and SPX weekly options. Sign up today for a free-trial and see how SPX Option Trader can be of benefit to you! US Search Desktop. We appreciate your feedback on how to improve Yahoo Search .
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Options are similar to futures, in that they are often based upon the same underlying instruments, and have similar contract specifications, but options are traded quite differently. Options are available on futures markets, on stock indexes, and on individual stocks, and can be traded on their own using various strategies, or they can be combined with futures contracts or stocks and used as a form of trade insurance. Options markets trade options contracts, with the smallest trading unit being one contract. Options contracts specify the trading parameters of the market, such as the type of option, the expiration or exercise date, the tick size, and the tick value. For example, the contract specifications for the ZG (Gold 100 Troy Ounce) options market are as follows: Symbol (IB Sierra Chart format): ZG (OZG OZP) Expiration date (as of February 2007): March 27 2007 (April 2007 contract) Exchange: ECBOT Currency: USD Multiplier Contract value: $100 Tick size Minimum price change: 0.1 Tick value Minimum price value: $10 Strike or exercise price intervals: $5, $10, and $25 Exercise style: US Delivery: Futures contract. The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly. For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30. Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell. Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).
Like futures markets, options markets can be traded in both directions (up or down). If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case, the trader does not care which direction the market moves. With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down. The following chart may help explain this further: Limited Risk or Limitless Risk. Basic options trades can be either long or short and can have two different risk to reward ratios. The risk to reward ratios for long and short options trades are as follows: As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk. Ready to start building wealth? Sign up today to learn how to save for an early retirement, tackle your debt, and grow your net worth.
However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades). 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 up front 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 options premium is calculated using three main criteria, which are as follows: In, At, or Out of the Money - If an option is in the money, its premium will have additional value because the option is already in profit, and the profit will be immediately available to the buyer of the option. If an option is at the money, or out of the money, its premium will not have any additional value because the options is not yet in profit. Therefore, options that are at the money, or out of the money, always have lower premiums (i. e. cost less) than options that are already in the money. Time Value - All options contracts have an expiration date, after which they become worthless. The more time that an option has before its expiration date, the more time there is available for the option to come into profit, so its premium will have additional time value. The less time that an option has until its expiration date, the less time there is available for the option to come into profit, so its premium will have either lower additional time value or no additional time value. Volatility - If an options market is highly volatile (i. e. if its daily price range is large), the premium will be higher, because the option has the potential to make more profit for the buyer.
Conversely, if an options market is not volatile (i. e. if its daily price range is small), the premium will be lower. An options market's volatility is calculated using its long term price range, its recent price range, and its expected price range before its expiration date, using various volatility pricing models. Entering and Exiting a Trade. A long options trade is entered by buying an options contract and paying the premium to the options seller. If the market then moves in the desired direction, the options contract will come into profit (in the money). There are two different ways that an in the money option can be turned into realized profit. The first is to sell the contract (as with futures contracts) and keep the difference between the buying and selling prices as the profit. Selling an options contract to exit a long trade is safe because the sale is of an already owned contract. The second way to exit a trade is to exercise the option, and take delivery of the underlying futures contract, which can then be sold to realize the profit. The preferred way to exit a trade is to sell the contract, as this is the easier than exercising, and in theory is more profitable, because the option may still have some remaining time value.
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