Investment basics: what is an option?

In previous episodes, we covered the very basics. But now I'd like to take a moment to digress to the "taller girl" topic, which is options. Thanks to @xenino for the suggestion. And don't worry, we'll come back to the biggest basics again.

Options? That's actually just a contract

What's an option?

An option(Important English term: Stock option) is a contract. That's how simple it is 😇

As I wrote in the introduction - we're getting into slightly more complicated waters here. An option is a financial derivative. That is, an instrument that allows us to perform an operation. In this case, to "guarantee" some right to operate on a security in the future. Ugh, that's pretty skeletal, huh? 😂

Let's put it another way - they are derivatives, i.e. their value is based on or derived from the value of the underlying security or asset. An option is essentially a contract that creates an agreement between two parties to sell or buy a stock at some point in the future at a set price, known as the strike price. This is called the strike price and is used quite commonly in the trading dictionary.

Options come in two forms. You can actually be on either side of the contract.

Call option (Again, the English term"call option/option. This is extremely important to know because it is used more often than the Czech variant) give the holder the right, but not the obligation, to buy an asset at a set price within a certain time frame.

Putoptions give the holder the right, but not the obligation, to sell an asset at a set price within a certain time frame.

Let's take an example:
If Tesla stock is trading at $800, it is worth exercising (i.e., exercising your right to convert to stock at the strike price)
a
call option
with a strike price of $850 only if the market price rises above $850.

Alternatively, a put option with a strike price of $800 is worthwhile if the stock price falls below $800. At this point, both options would be said to be in the money (ITM), meaning they have some intrinsic value (specifically, the difference between the strike price and the market price). Otherwise, the options are out of the money (OTM). However, OTM options still have value because the underlying asset has some probability of moving into the money on or before the expiration date. It simply can still reverse. This probability is reflected in the price of the option.

However, we can also use options to take a long or short position in a stock without actually buying or shorting the stock. Long and short are terms I have not explained yet, hence the short version.We "long" when we buy a stock and hope it will rise. We short when we bet on the stock to fall. By the way, the phrase "hold to long" and "short" is more commonly used.

Shorting is an investment or trading strategy that speculates on a decline in the price of a stock or other security. However, it is really no longer "higher maiden".

Traders can use short selling as speculation, and investors or portfolio managers can use it as a hedge against the downside risk of a long position in the same or a related security. So-called hedging.

In a short sale, a position is opened by borrowing a stock or other asset that the investor believes will decline in value. Perhaps in the form of options. The investor then sells these borrowed shares to buyers who are willing to pay the market price. Before the borrowed shares have to be returned, the trader is betting that the price will continue to fall and he will be able to buy them at a lower price. The risk of loss from short selling is theoretically unlimited because the price of any asset can rise indefinitely. The converse is of course limited, since the price cannot fall below zero.

So we now know what a call, put, short and long are. So know that they can be combined with each.

Long Call

A trader who expects the stock price to rise can buy a call option to buy the stock at a fixed price (strike) at a later date, instead of buying the stock outright. The cash outlay on the option is the premium. The trader would have no obligation to buy the stock, but only the right to do so on or before the expiration date. The risk of loss would be limited to the premium paid, as opposed to the potential loss of buying the stock outright. Thus, he paid more for the option than he would have paid for an ordinary share. This difference is his only possible loss. If the spot price of the stock rises by more than the premium for buying the option over the stock, he is in the black. He has made more than if he had just bought the underlying stock.

Long Put

A trader who expects the price of a stock to fall can buy a put option that allows him to sell the stock at a fixed price (strike) at a later date. The trader is not obligated to sell the stock, but has the right to do so on or before the expiration date. If the price of the share on the expiration date is less than the strike price by more than the premium paid, the trader makes a profit. The more the stock falls, the greater the profit. If the price of the stock at expiration is higher than the strike price, the trader lets the put contract expire and loses only the premium paid.

Short Call

A trader who expects the price of a stock to fall may short that stock or sell, or "underwrite," a call instead. The trader selling the call is obligated to sell the stock to the call buyer at a fixed price (strike price). If the price of the stock falls, the seller of the call option (the writer of the call) makes a profit equal to the premium. If the share price rises above the strike price by more than the premium, the seller loses, and the potential loss is again theoretically unlimited.

Short Put

Again, more or less the opposite of the previous one. A trader who expects the price of a stock to rise can buy that stock or sell, or "subscribe" to, a put option instead. The trader who sells the put is obligated to buy the stock from the buyer of the put at a fixed price (strike). You can probably figure out the rest - If the price of the stock at expiration is higher than the strike price, the seller makes a profit equal to the premium. If the share price at expiration is below the strike price by more than the amount of the premium, the trader loses.

That's about it for explaining the basics of options and their most common uses. i hope this has helped even just a few people to understand this already somewhat complex instrument 😇

As always, I'll add a video afterwards just in case:

https://www.youtube.com/watch?v=VJgHkAqohbU

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Disclaimer: This is in no way an investment recommendation. This is purely my summary and analysis based on data from the internet and a few other analyses. Investing in the financial markets is risky and everyone should invest based on their own decisions. I am just an amateur sharing my opinions.

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Traders can use short selling as speculation, and investors or portfolio managers can use it as a hedge against the downside risk of a long position in the same or a related security. So-called hedging.

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