Among the fundamental concepts that you'll read about as you begin to educate yourself about options trading are puts and calls. These are the only two types of stock options that you can buy or sell. Before getting into how to use puts and calls, let's define exactly what calls and puts are.
Call Options
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A call option is a legally binding contract that gives you the right but not the obligation to purchase a particular number of shares of stock at a particular price (i.e., the "strike price") at any time prior to its expiration. A call option will increase in value if the price of the underlying stock goes up. If the price of the stock goes down, the value of the call option goes down as well. Traders purchase calls when they believe that the price of the stock is going to go up because they will have the opportunity to buy the underlying stock at a price below market value when everybody else has to pay full retail price. He or she can then sell the stock for a profit. If the trader chooses not to exercise the option, then he or she can instead sell the call option to someone else for a nice profit. That would give the new buyer of the call option the right (but not the obligation) to purchase the stock for less than retail.
Put Options
A put option is a legally binding contract that gives you the right but not the obligation to sell a particular number of shares of stock at any time before its expiration, whether or not you own the underlying stock. Traders purchase puts if they believe that the stock will go down. Put options increase in value when the price of the underlying stock decreases. If the stock goes up, the value of the put option decreases.
How to Use Puts and Calls
Both types of options can be purchased or sold. Your decision to buy or sell, as well as your choice of call or put, depends on your options trading goal(s). The options trading systems that you'll encounter will involve only puts, only calls, or some combination of the two. It's the "some combination of the two" that allows you to make money regardless of market conditions, but more on that later. As mentioned above, buying a call affords you the right to buy the asset at the strike price on or before the option's expiry date, whereas buying a put affords you the right to sell the asset on or before the option's expiry date. As the option holder, you can sell the option to another buyer during its term or just let it expire if you want.
Options are protective instruments because they protect either before or after a stock commitment. You can buy an option to protect a purchase or sale that has already been made or will soon be made. You can also buy a put option to protect the stock that you hold, or to protect yourself against unlimited loss when you buy a stock. In addition, puts can be bought in order to protect a profit which you have already made and don't want to lose. Further, you can buy a put or a call to protect yourself against a commitment that you expect to make at a future date and on which, when you make such a commitment, you don't want to take an unlimited risk. The bottom line is that options are protective, no matter how they are used.
If that's the case, then why do so many option traders lose their proverbial shirts? It's because they fail to make adjustments in their positions in response to changing market conditions. All they know how to do is make puts and calls; they don't know how to mitigate risk, which is done through the use of adjustments. Unfortunately, many options trading courses do not teach anything about adjustments, and that's why so many people fail at options trading.
How to Use Puts and Calls
Learning options trading the "right" way can save you a lot of time, money, and frustration. It's imperative to have a firm grasp of the fundamentals before you even begin paper trading, let alone trading with real money. Go to http://www.optionstradingstar.com/ for easy-to-understand explanations of options trading principles.
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