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What You Should Know About Investing with Options

By: Elite Legacy Education, December 8, 2016

What You Should Know About Investing with Options

Everyone loves having options, but this is particularly true for advanced traders. Options are a financial instrument that can be extremely useful –– so long as you know how to use them.

 

So what exactly are options?

As we’ve mentioned in a previous article, options represent a contract between two parties – the option buyer and the option writer. Specifically, the writer grants the option buyer the right to buy or sell an underlying asset at a pre-determined price and pre-determined date. The pre-determined price is referred to as the strike price, while the pre-determined date is known as the expiration date.

It should also be noted that a premium is paid to the option writer since they will be the one who is obligated to uphold the deal if the buyer wishes to exercise the option.

 

Are there different types of options?

Yes, there are. Options can either be considered a call option or a put option, which are described below:

  • Call Option: This gives the option buyer the right to buy an asset at a particular price in the future. Thus, the buyer would want the price of the asset to increase (i.e., taking a long position) so they can then exercise the option to purchase at a lower price and capitalize on the difference. On the other end, the issuer would want the stock price to drop (i.e., taking a short position) since the option buyer would not exercise the option. In this case, the option writer would still receive the premium.
  • Put Option: This gives the option writer the right to sell at a particular price in the future. If the price drops below the strike price, then the buyer must purchase at this price point. In this case, the writer would want the price to drop below the strike price, so the buyer is forced to pay the previously higher price. Thus, the option writer would capitalize on the differential. On the other hand, buyers would want the price to increase above a certain threshold so that writers would have to sell at the previously lower price. At this point, they would have secured the previous lower price and could resell the new stock at a higher price.

 

Putting options into action.

Options are primarily used for two reasons – for trade speculation and for risk hedging. Speculation refers to betting on the direction of the underlying asset price, while risk hedging would seek to reduce the potential for losses on the underlying asset. Here are some strategies for achieving each of these purposes:

  1. Protective Put: A protective put is essentially a defensive investment strategy meant to hedge risk. It is intended to protect unrealized gains and is used when you’ve invested in an asset that you believe will appreciate further. Say you’ve invested in a stock and its price has increased since you purchased it. You do not realize this gain until you sell it. Thus, to protect this unrealized gain you can buy a put option as a safety measure. Specifically, if the price of the asset then falls, you can exercise your put option to minimize the losses. Remember that a put option is essentially a short position since you’re betting on the underlying asset price dropping. This is contrary to your long position on the asset, which means that it will help to minimize losses should the asset price depreciate.
  2. Covered Call: A covered call is essentially used to enhance your earnings on the appreciation of an underlying asset that you’ve also invested in with a long position. Essentially, you would issue a call option (i.e., take a short position as the option writer). This could play out in three ways. The first is if the price drops, then the option becomes worthless and you collect a premium for issuing the option. The second is if the price remains the same and you again just collect the premium. The final situation would be if it raises above the strike price. In this final case, if the price rises above the strike price plus the premium, then you would have sold yourself short and not realize the full gains since the option buyer would exercise their right.
  3. Straddle: A straddle occurs when you hold both a call option and a put option on the same security with the same expiration dates. In this case, you will benefit either way since you just exercise the option that was right. However, since you are paying premiums on each of these options, you ideally go for significant variations in the underlying asset price that will offset the money spent on premiums.

 

So as you can see, you’ve got lots of options when it comes to options. Just make sure you understand these financial instruments before putting your money on the line.

Used correctly, stock options can increase your profit potential exponentially while also reducing your risk significantly. Our Rich Dad Education trainers will introduce you to options basics and explain how you can control a stock for a fraction of its price, profit from stock you don't own, and make money when the price of a stock is barely moving at all.

Don’t miss out on all of the ways Rich Dad Education can help you reach your goals in life!

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