There are two types of ‘options’ that can be purchased: options to buy and options to sell. If you’re buying an option to buy something at a specific price before a certain date, then this is known as a ‘call option.’ On the other hand, if you’re buying an option to sell something at a certain pre-determined price before a specific date, then this is known as a ‘put option.’
The difference between these two lies entirely in which way round they run. If you’re planning on profiting from the rise in such assets (buying call options), then sell them off once their value has gone up, or if you want to use them as insurance against significant losses (buying put options), then sell them off once their value has gone down.
These two terms are used to precisely explain what an individual is buying when they purchase either of these contracts. While this may seem complicated at first, rest assured that you will have a thorough understanding of how options work and why they’re so valuable by the end of this article.
What is an option?
At its very basic level, an ‘option’ is described as being the right but not obligation to buy or sell something at a pre-determined price during a specific timeframe. You can think of it almost like renting out something for a fixed period.
How does an option work?
An excellent example of this is, let’s say we’re renting out an apartment, and the landlord says you can rent it for the month but doesn’t tell us when over that period they expect us to move in or move out. This means we could choose to arrive much earlier than expected and wait for them to turn up so we can sign our lives away. The owner has given us an option to use their property, and they must allow us to do so until the contract runs out.
In finance terms, this is almost precisely how an ‘option’ works: people buy ‘options’ from other institutions to temporarily gain the right (and no obligation) to purchase something at a specific pre-determined price.
What are called options?
Called options are generally used by institutions or individuals looking to profit from the fluctuations of the market’s volatility, while put options are more commonly used as a form of insurance against significant losses.
How does call options work?
A ‘call’ option is essentially the right (but not obligation) to buy something at a specific pre-determined price before a certain date, sold by someone who already owns that thing.
An investor will usually buy this option for themselves because they expect that the value of what they’re buying will rise before that time comes around, thus allowing them to sell it off at a much higher rate than what was initially paid for it. If one were to purchase an option on Microsoft stock then sell it once its value has shot up, the investor would profit.
What are put options?
On the other hand, if you’re buying an option to sell something at a certain pre-determined price before a specific date, then this is known as a ‘put option.’ The difference between these two lies entirely in which way round they run. If you’re planning on profiting from the rise in such assets (buying call options), then sell them off once their value has gone up, or if you want to use them as insurance against significant losses (buying put options), then sell them off once their value has gone down.
Finally
New investors and beginner traders are advised to use reputable online options trading brokers in UK like Saxo Bank before starting their investment journey. Trade on a Saxo Bank demo account before investing real money.
