Understanding the Basics of Options Trading: Calls and Puts
Options trading is becoming increasingly popular in the United Arab Emirates (UAE). Options are contracts that give buyers the entitlement but not the obligation to buy or sell a specific asset, such as shares, at a pre-agreed price on or before a specified date. Call and put options are two of the most common types of options trading. Call options give buyers the entitlement to buy an asset on or before expiry, while put options give buyers the entitlement to sell an asset on or before. This article will discuss the basics of call and put options in options trading in UAE.
What are calls?
A call option is a contract that provides the buyer with the entitlement, but not the responsibility, to purchase an asset at a set price (the strike price) before or on the option's expiry date. A call option's value increases when the underlying stock rises in price and decreases with a fall in its price. The amount gained by exercising a call option is its payoff.
The premium paid for buying a call option consists of two components: intrinsic value and time value. Intrinsic value is built into the option's current market price and reflects how much it would be worth if exercised immediately; time value represents a potential appreciation of an asset over the life of an option contract.
What are puts?
Unlike a call option, a put is a contract that provides the buyer with the entitlement, but not the responsibility, to sell an asset at a set price (the strike price) before or on the option's expiry date. Since put options have values that increase when their underlying stock falls in price, they are often used as hedging instruments.
Like calls, puts also have intrinsic and time value premiums. Intrinsic value is built into the option's current market price and reflects how much it would be worth if exercised immediately; time value represents a potential appreciation of an asset over the life of an option contract.
The payoff for a put option is its intrinsic value minus the strike price; this amount can be either positive or negative, depending on whether the stock has risen or fallen in price.
What are some of the risks associated with options trading?
Like any other type of investment, options trading carries certain risks, and losses could occur if trades are not adequately managed. The trader must thoroughly understand the underlying asset being traded and market conditions to minimise potential losses. You can consult a broker located locally, such as Saxo FX broker in the UAE if you want to trade forex options and want to learn how to mitigate the risks.
Volatility risk is the potential for a significant, unexpected change in the underlying security price. Options traders need to be mindful of the potential for significant and sudden changes in market conditions that can result from news events or geopolitical developments. It makes traders constantly monitor their positions and adjust their strategies accordingly.
Time decay is an essential concept for options traders as it affects how long they have until expiry. Options contracts typically lose value over time due to the short contract periods; losses could occur if no profits are generated before option expiration. Traders must also consider that there may be a lack of liquidity in the underlying asset, which could reduce their ability to exit a trade profitably.
Counterparty risk is the potential for one party to a financial transaction to default on its obligations. Options traders must know the counterparty risk involved when trading with counterparties with insufficient capital reserves to cover their losses. They must do their due diligence and research before entering a trade to ensure the counterparty has sufficient resources to avoid defaulting on any commitments.
Leverage risk refers to the potential for losses to be amplified due to using borrowed funds. Options trading involves leveraging, increasing a trader's profits and magnifying losses. Traders must consider the amount of leverage they are exposed to and ensure that margin requirements are always met.
Market risk refers to the potential for losses due to general market conditions. Options traders need to be aware of the macroeconomic and geopolitical environment at all times, as this can affect the price of their underlying asset. They must continually monitor market developments and adjust their strategies accordingly.