An option is a contract between two parties and, as in every contract, we have a buyer and a seller. Depending on who you are, you will have a right or an obligation to assume some responsibilities.
Options are called “derivates” because they derive from an original or underlying product, which can be stocks, indices, futures, currencies, etc.
When you buy an option you are purchasing a right, while the opposite side of the contract, the seller of the option, is taking an obligation. The buyer, for acquiring that right, will be obliged to pay and the seller, for acquiring that obligation, will receive a premium.
There are only 2 types of options: calls and puts
If you buy a Call option (Long Call) you are purchasing the right to buy 100 shares at a specified price (Strike Price) at a given date (Expiry Date) and the other side, the seller of the Call Option (Short Call) is taking the obligation to sell these shares at a price determined by the date specified.
And put options are similar, but opposite. If you buy a Put option (Long Put) you are purchasing the right to sell 100 shares at a specified price (Strike) on a certain date (expiration), and the seller (Short Put), acquires the obligation to purchase such shares at a price determined on the date determined.
In summary:
– The buyer acquires the right Option (he pays) and the seller acquires the obligation Options (he get money for it)
– There are 2 types of options: Call and Put, and thus 4 types of basic operations
Long Call: right to buy the stocks at strike price on expiration date
Short Call: obligation to sell the stocks at strike price on expiration date
Long Put: right to sell the stocks at strike price on the expiration date
Short Put: obligation to purchase the stocks at strike price on the expiration date.
– Remember that every contract refers to 100 shares
Spread Trades
And spread trades are simply combinations of the 4 basic operations with one another and / or adding the purchase or sale of shares.
Depending on the structure of the spread and the choice of strike price and expiration date of each option, we can create a multitude of strategies:
– To optimize a movement (Bullish, Bearish or Lateral)
– To generate income
– To hedge positions
– Speculative strategies, or more conservative
– Etc.
Examples of spread trades would be: Straddle, Strangle, Covered Call, Collar Trade, Calendar Call, Bull Put, and so on.
Risk of Options
It is said that options are very risky. In fact, they are not risky, but who use them and how they are used is what makes them risky.
Before you start trading with options, the first step is knowing the risks associated with them. To do this, it is worth reading the official publication on risk associated with options OCC.
This publication can be found at the following link: http://www.optionsclearing.com/publications/risks/riskstoc.pdf
