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While unfolding the topic of options trading, we first need to have a clear understanding of what the term ‘options’ signify. Options to an investor is an investment option very much like mutual funds, stocks and bonds but at the very same time options differ from the other types of securities listed above in being a bit more complex than these. Options can be defined as a contract that gives the owner the right to buy or sell an asset at a specific price on or before a specific date. It is called options because the buyer has the right but not the obligation to trade his stocks and thus enjoys the advantage of limited risks but unlimited profit potential.
Options are of two types depending on whether it is the right to buy or sell an asset. In case it gives the owner the right to buy an asset at a specific price within a specified period of time then it would be categorized as a ‘call’. And on the other hand if it is the right to sell an asset under the same conditions then it would be a ‘put’. Buyers of call have long position and that means that they are full of hope that the prices of the securities will rise within the stipulated time frame. Whereas buyers of put have a short position and earnestly hope that prices of securities would fall before their option expires.
The options market involves four different types of traders that include buyers and sellers of call and buyers and sellers of put. The advantage of holding options is that options empower you to make money not only when the option price goes down but also when the market is dwindling. That is one reason that one needs to be extremely speculative while trading with options. When you buy options it means that you not only have to predict whether the market will fall or rise but you also have to have an approximate idea as to how much the prices will go up or down and within what time frame since options definitely expires after a specific period.
Options can also be categorized as being of two different types: American Options and European Options. American options can be exercised at any point of time between the date of its purchase and its expiry date, whereas European options differ from the former in being exercisable only at the end of their lives.
Options can be speculative or conservative. Speculative options as discussed earlier give the buyer or the investor the benefit of profiting even when the market in general is plunging or is stagnant. Options can also be conservative in the sense that the investor might use stock options to hedge. Hedging phenomenon can be compared to an insurance policy. Just as any personal property might be insured against any loss or damage, in a similar way, the investor can employ hedging strategies that enable him to be benefited only when the stocks enjoy an upward trend and through hedging he can also limit his losses and restrict his downside.
As an aside, we might just add that options also include employee stock options, which are a lucrative means of tempting and sustaining suitable candidates by various reputed companies world over.
To conclude, options apart from being extremely complex securities also involve immense risks. That’s the main reason why options trading is never considered suitable for all investors; and most of the times novices are advised to steer clear of options trading. Options can very easily become a liability instead of being an asset if dealt with unwisely. So educating yourself on the various aspects of options trading is considered mandatory before treading these unsafe waters.
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