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Options Trading

You have seen many wealthy individuals make lots of money using options and you want to try options trading, too.

Options are a contract conferring the right to buy (a call option) or sell (a put option) some underlying instrument, such as a stock or bond, at a predetermined price (the strike price) on or before a preset date (the expiration date).

So-called ‘American’ options (written for stocks and bonds) can be exercised anytime before expiration, ‘European’ options (written on indexes) are exercised on the expiration date.

Since all have a set expiration date, the holder can keep the option until maturity or sell before then. A great many investors do in fact hold until maturity and then exercise the option to trade the underlying asset.

Now suppose the market price is below the strike price, but the option is soon to expire or the price is likely to continue downward. Under these circumstances, it may be wise to sell before the price goes even lower in order to curtail further loss. The investor can, at least, minimize the loss by using it to offset capital gains taxes.

The final basic alternative is to simply let the contract expire. Unlike futures, there’s no obligation to buy or sell the asset – only the right to do so. Depending on the premium, strike price and current market price it may represent a smaller loss to just ‘eat the premium’.

Observe that options carry the usual uncertainties associated with stocks: prices can rise or fall by unknown amounts over unpredictable time frames. But, added to that is the fact that options have – like bonds – an expiration date.

One consequence of that fact is: as time passes, the price of the option itself can change (the contracts are traded just like stocks or bonds). How much they change is influenced by both the price of the underlying stock and the amount of time left on the option.

Selling the option, not the underlying asset, is one way to offset that premium loss or even profit.

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