You already know what an option is and how trading in options works. Before you can start trading options, it’s important that you know how to select the right options and how you determine the profits and losses.
Select an option
Trading options requires strategic thinking. It’s important to consider the possible direction of the price and if a certain value will be reached. Consequently you can find an option that fits your prediction.
For example, if you think that a share of Philips stock that is worth 18 pounds today will be worth 20 pounds within three weeks, you take a call option with the price of 20 pounds and an expiration time of a month. If you think that the share will go down to 16 pounds within 4 months, you take a put option with a price of 16 pounds and an expiration time of 4 months.
Profits and losses with options
Options expire every third Friday of the month. If your option is earning you money, you can exchange your option for stocks. You buy a stock cheaper than the actual price. However, it’s simpler and cheaper (less fees) to sell the option before the expiration date.
It’s also possible to sell the option before the expiration date. Depending on the intrinsic value and the projected value, you can get a certain amount for your option. The real profit you make can always be calculated from the paid fees minus the received money.
If your option is out of money on the expiration date, then your option has become worthless. You can then let your option expire and no other action is required. The loss consists of the fees you paid.
Writing an option
Besides buying an option, you can also write an option. When you buy an option you receive a right; when you sell an option you commit to an obligation. You need to sell at a certain value (call option) or buy at a certain value (put option). In exchange for this commitment, you receive a contract from the buyer for a certain fee, which is your profit.
If you write an option, you make money when you don’t need to carry out the contract. Thus, you want to write an option for a price that you think won’t be reached. The more favourable the terms for the buyer, the higher the fee you receive. By finding the edge of your prediction, you’ll make more money.
If you’ve written an option, you can close it prematurely by trading it on the exchange. For writing a position you need a certain margin at a broker so you can deliver the asset at the promised rate; after the expiration date, the buyer of the option can obligate you to deliver the asset as stated.