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Share trading
Make money from options
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Why options?
Options enable you to make money on a declining market, as well as when it is rising. For this reason, options offer an exciting investment opportunity when markets are volatile.
Although the risks are high, so are the potential rewards. As a traded option buyer, you can trade with small amounts of money and make proportionately much higher gains than if you were investing in the underlying share or index. You can also lose your entire investment.
What is an option?
An option is a financial instrument that enables you to bet on the movement of individual shares or indices, as well as of currencies, commodities or interest rates.
It gives you the right, but not the obligation, to buy or sell a security at
a pre-determined price (strike or exercise price) within a specified time period
or (less commonly) at a specified time.
You can exercise an option (buy or sell the underlying security) to establish
any profit that may be available to you or, as most prefer, simply trade it
in the market.
Intrinsic and time values
Intrinsic value is how far the underlying stock's value surpasses the option strike price. An option, therefore, has intrinsic value only when it is in the money.
The option's time value is defined as its total value less intrinsic value. The more time an option has until it expires, the higher this figure will be.
Basic strategies
City traders use the Black-Scholes model to value options. This takes into account the intrinsic value of the option, its time value, and the fact that it does not pay dividends.
This model assumes that that the stock price moves randomly, which is sometimes wrong. If as an investor you can spot anomalies in value among options that have been priced according to the formula, you can make money.
If you are optimistic
If you think the underlying security or index will rise in the short term, buy a Call option. Following any rise, you may sell your traded option on the market and cash in on any profit.
A riskier alternative strategy to buying a Call option is to become the writer of a Put option.
If you are pessimistic
If you think that the company's share price will fall, buy a Put option. However, as an alternative, you could write a Call option.
If you are in doubt
If you expect the underlying stock to move significantly, but you don't know in which direction, use a straddle. In a long straddle, you will buy a Call option and Put option at an identical strike price and expiration dates.
To find out more about making money on traded options, read Everyone's Guide to Online Stock Market Investing by Alexander Davidson.
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