If the stock price of XYZ Corp. drops to $30 or below within the next 3 months, you can exercise your option and sell XYZ Corp. stock for $40. This means you will receive $10 per share (after deducting the cost of the option you paid).
Conversely, if the stock price of XYZ Corp. does not drop to $40 or below within the next 3 months, you will not exercise your option and you will only lose the $3 option premium you paid.
What are the characteristics of options?
1. Two-way trading
In traditional transactions, investors are merely buyers and can only hope to earn the difference in price if the price goes up. Once the price goes down, they can only accept the loss.
In options trading, investors can invest as buyers or sellers and make profits based on the rise and fall of the value of the underlying asset. Therefore, when the stock price falls, profits can also be made through options trading.
For example, if you predict that a stock is about to fall, traditional investors will either sell to stop losses or continue to hold and wait for it to rise again. Option trading allows investors to buy put options or sell call options to trade, which means that they can also make profits during the stock’s decline. The two-way trading model gives investors more strategic options.
2. Unilateral power
Options trading gives the buyer the right to exercise.
When trading options, buyers can choose to exercise or not exercise the option based on the market conditions of the underlying asset of the futures contract.
When the buyer proposes to exercise the right within the contract period, the seller has the obligation to fulfill the option contract.
3. Profit and loss are not equal
Because the power to exercise option trading is in the hands of the buyer, the buyer will only buy or sell the futures contract when it is beneficial to him.
- If it is in the buyer’s favor, his profit is usually unlimited;
- If the price is unfavorable, the loss will not exceed the option premium. Compared with futures trading, the buyer’s loss in option trading is greatly reduced, and generally the loss is just the option premium.
For the seller of an option contract , the maximum profit is the option premium of the option contract, but the loss will depend on the content of the futures contract, and in most cases the loss may be unlimited.
This characteristic of mismatched profits and losses gives option trading a unique advantage in risk management.
