If you want to be a profitable trader, you have to know the basics.
Both new and veteran traders can benefit from reviewing foundational information, including the definition of an option contract.
David Jaffee of BestStockStrategy.com understands the importance of building a solid foundation from the basics.
While many options trading coaches and courses like to overcomplicate the process, David Jaffee knows that a simple strategy can be the most profitable.
For those who want to trade options, start from square one.
What is an option contract?
Option Contract Definition
Like any standard contract, an option contract serves as an agreement between parties.
Option contracts bind both parties to sell, or buy, the underlying security at the expiration date.
Option contracts specify the underlying security, the strike price, and the expiration date.
Option contracts differ from stocks because they do not exist in perpetuity (they have an expiration date) and they are derivatives.
After the expiration date, the option ceases to exist, whether it has value or expires worthless.
When dealing with stock options, one option contract allows for control of 100 shares of an underlying stock.
Option contracts are available on many different underlying assets, including stocks, ETFS, bonds, currencies and commodities.
It is important to remember that an option contract gives the buyer the right to exercise the option, but they are not obligated to do so.
Option contracts are usually referred to simply as “options.”
Options are used to enhance an investor’s portfolio, speculate, generate income, and more.
This may all sound like common knowledge to an experienced trader, but it is crucial to understand the basics so that you can become successful at trading options.
Types of Option Contract
There are two types of option contracts: put options and call options.
As a derivative security, the price of an option is linked to the price of an underlying asset.
When an option is sold, the seller, or writer, collects option premium from the buyer.
The terms of the option contract differ based on the type of option.
A put option is an option contract that allows the owner of the contract to sell a certain amount of an underlying security.
The sale can only take place at a set strike price on, or before, the predetermined expiration date, but the put option owner is not obligated to sell.
A trader can sell put options, collecting option premium from the buyer.
If the price of the underlying asset decreases, the value of the put option increases (in general, if it gains value faster than the time decay).
A put option loses value if the price of the underlying asset increases (and as it gets closer to expiration).
There is a considerable risk in buying an option contract, and David Jaffee would recommend selling option premium to minimize risk when trading (although there are certain times when it's best to buy options).
In fact, you can win almost every trade if you follow the best options trading strategy and sell option premium.
A call option is an option contract, giving the buyer the right to buy a predetermined amount of an underlying asset.
The buyer of the option is not obligated to exercise this right, but they can buy an asset at the set strike price within the set time period.
As with put options, call options are sold by a writer who collects option premium from the buyer.
When the value of an underlying asset increases, the value of the call option increases (as long as it gains value faster than the loss of value due to time decay).
If the underlying asset falls in price, the value of the call option decreases.
A call option example: let's say that a trader expects a stock to rise in price in the near future, then the trader buys a call option contract for $2.50 with a strike price of $50 per share.
The option seller collects $250 of option premium for selling one option contract (each option allows control over 100 shares of stock).
The seller (option writer) gets to keep the premium regardless of what happens to the underlying stock.
If the price of the stock rises to $70 before the option’s expiration date, the owner of the call option can exercise their right to purchase 100 shares of the stock at the strike price of $50.
The trader can then sell their shares at the current market value of $70 per share for a total of $7,000. The profit of the trade is the total amount made in the sale minus the cost of the shares and the option premium.
In this example, the profit would be $1,750 ($7,000 - $5,000 - $250).
The option buyer can also sell their option and reap a similar amount of profit (that way they can avoid exercising their option contract into shares of stock).
However, if the price of the stock does not reach a price of at least $52.50, then the option buyer will lose money; and if the stock does not reach $50 by the expiration date, then the option contract expires worthless and the buyer loses their option premium of $250.
Option Trading Strategies: Sell Option Premium
David Jaffee teaches his students the right way to trade options by selling option premium.
While many investors take on the risk of buying call or put options, selling option premium minimizes risk and maximizes the potential for profit.
Instead of gambling on an option contract, selling options enables traders to act like the casino.
When you sell options, you collect money, option premium, upfront and generate income.
Selling option premium is not considered the most flashy or complicated options trading strategy, but it is a safe way to become a profitable trader and generate income (as long as you don't trade too large).
To learn more about options trading, visit BestStockStrategy.com and learn how to trade options from David Jaffee.
Frequently Asked Questions (FAQs)
What is an options contract?
An options contract is an agreement between two parties to facilitate a potential transaction involving an asset at a preset price and date
How does an options contract work?
If you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock.
Is option contract risky?
Options contracts are not risky if you are knowledgeable about how to mitigate risk.
What are the 4 types of options?
There are four basic options positions: buying a call option, selling a call option, buying a put option, and selling a put option. With call options, the buyer is betting that the market price of an underlying asset will exceed a predetermined price, called the strike price, while the seller is betting it won't.
Why option buying is not good?
Buying options has a probability of profit below 50%, but the magnitude of the gains can be very high. Traders sometimes lose money because they try to hold the option too close to expiry. Normally, you will find that the loss of time value becomes very rapid when the date of expiry is approaching. Hence if you are getting a good price, it is better to exit at a profit when there is still time value left in the option.
How does an option contract make money?
An option buyer makes money if the option is in the money by more than the premium paid. An option seller makes money if the option is in the money by less than the premium paid (or if the position expires out of the money).
What is option trading?
Option trading is the trading of instruments that give you the right to buy or sell a specific security on a specific date at a specific price.