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Options Explained

Options Explained

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Published by Matthew Brown
Learn what an option can do to help you profit with your investment capital. This document has been written for beginners wanting to know how they can use options as a means to profit from rising and falling markets.
Learn what an option can do to help you profit with your investment capital. This document has been written for beginners wanting to know how they can use options as a means to profit from rising and falling markets.

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Published by: Matthew Brown on Oct 15, 2007
Copyright:Attribution Non-commercial

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10/25/2012

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Page 1 of 17
 © Copyright FMRAnalysts, 2007. All rights reserved.
Options – Explained
 
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price. This can occur on, or before, a predetermined date. To have thisright, the taker (buyer) pays a premium to the writer (seller) of the contract.
 Index
 How options can benefit you.........................................................................................................................2Terminology..................................................................................................................................................4Call Options..................................................................................................................................................5Put Options ...................................................................................................................................................6Advantages of Option Trading.......................................................................................................................7Pricing Options .............................................................................................................................................8Key factors which affect the time value of an option are:.............................................................................10Who are the Takers and Writers?.................................................................................................................11Index Options..............................................................................................................................................13Payoff Diagrams .........................................................................................................................................14Resources....................................................................................................................................................16Disclaimer...................................................................................................................................................17
 
Page 2 of 17
 © Copyright FMRAnalysts, 2007. All rights reserved.
How options can benefit you
 There are a number of reasons an investor/trader may get involved in options:
 ·
Leverage
 ·
Earning Extra Income
 ·
Protecting the value of your shares
 ·
Capitalizing on share price movements without having to purchase shares
 ·
Time to decide what to do
 ·
Index options let you trade all the stocks of an index
 ·
Multiple strategies to limit risk 
 Leverage
 First and foremost, a trader will choose to trade options over shares because of leverage.In finance,
leverage
(or 
gearing
) is using given resources in such a way that the potential positive or negativeoutcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase thereturns.Options generally cost a fraction of a share price, but increase (and decrease) and a higher percentage to thestock price movement. There are many other factors involved with leverage in options, which are explainedthroughout this document.
 Earning Extra Income
 Writing options against shares you already own or plan to purchase can be one of the simplest and mostrewarding strategies.
 ·
Writing options against shares you already own
 ·
Writing options at the same time as buying shares
 ·
Writing options to sell your shares above the current market price
 Protecting the value of your shares
 This strategy can be useful if you are a shareholder in a particular company and are concerned about a short-term fall in the value of the shares. Without using options you can either watch the value of your shares fall, or you could sell them. Using options could give you some protection from this decline.Writing call options to give you downside protectionTake (purchase) put options
 
Page 3 of 17
 © Copyright FMRAnalysts, 2007. All rights reserved.
Capitalizing on share price movements without having to purchase shares
 You can profit from a movement, either up or down, in the underlying shares without having to trade theunderlying shares themselves.Take (buy) calls when expecting the market to riseTake (buy) puts when expecting the market to fall
 Using options gives you time to decide
 Taking a call option can give you time to decide if you want to buy the shares. You pay the premium, which isonly a faction of the price of the underlying shares. The option then locks in a buying price for the shares if youdecide to exercise. You then have until the Expiry Date of the option to decide if you want to buy theunderlying shares.Put options can work in a similar fashion. By taking a put option you can lock in a selling price for shares youalready own and then wait until the Expiry Date to see if it is worthwhile exercising the option and selling your shares. Otherwise, you can let the option lapse and continue to hold your shares.In both cases, the most you can lose is the premium you have paid to purchase the option in the first place.
 Index options let you trade all the stocks in an index with just 1 trade
 By using call and put options over an index, you can trade a view on the general direction of the market, or hedge a portfolio with just 1 trade. If you are bullish on the market but don’t know what stock to buy or whichsector of the market will rise, you can buy a call option over the whole index. This means you don’t have tochoose a particular stock to invest in, you can just take a view on the direction of the broad stockmarket. If thelevel of the index rises the value of the call options will rise, just as for call options over individual shares.
 Other strategies
 Options can allow you to construct strategies that allow you to take advantage of many market situations. Thesecan be quite complex and involve varying levels of risk. What this allows the trader/investor to do is benefitfrom market conditions where there is a lack of direction, or when markets are falling.

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