How does options trading differ from traditional stock trading?

Options trading and traditional stock trading operate very differently. When you trade stocks, you are buying or selling actual shares and become a partial owner of the company. In options trading, you are purchasing a contract that gives you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time period. Because you’re dealing with contracts rather than owning the asset directly, the capital required is typically lower compared with buying shares outright.

What is a possible loss in a long option position?

The maximum loss when you buy (go long on) an option is limited to the premium you paid for the option. If the market doesn’t move in your favor and the option expires worthless, you lose only the premium, but no additional money beyond that. This means your risk is clearly defined and capped upfront, unlike owning the underlying asset where losses can be much larger. While losing the entire premium is possible, you never owe more than what you initially invested, making long options a way to control risk effectively.

What is the role of options in amplifying exposure and how does it work?

Options trading allows investors to control a larger position in the underlying asset with a relatively small amount of capital, known as the premium. By paying premium, traders gain the right to buy or sell the asset at a specific price within a set time, without having to invest the full price of the asset upfront. This amplifies the potential returns because a small change in the price of the underlying asset can lead to a much larger percentage gain on the option itself. However, this also increases risk: if the market moves against the position, the entire premium paid for the option can be lost, sometimes very quickly. Therefore, while options can magnify profits, they can also magnify losses in options trading.

Can I profit from both rising and falling markets using options?

Yes, options trading allows you to take both long and short positions by buying different types of options. When you expect the price of an asset to rise, you can take a long position by buying a call option, which gives you the right to purchase the asset at a set price. Conversely, if you expect the price to fall, you can take a short position by buying a put option, which gives you the right to sell the asset at a predetermined price. This way, options let you potentially profit from both rising and falling markets without owning the underlying asset directly.

How is the price of an option determined?

The price of an option, known as the premium, is determined by several key factors. These include the current price of the underlying asset, the option’s strike price, the time remaining until expiration, and the volatility of the underlying asset. Time also plays a role - options lose value as they approach expiration, a concept called time decay. Volatility affects the premium because higher volatility increases the chance that the option will become profitable, making the option more expensive. Other factors, such as interest rates and dividends, can also influence option pricing.

What is the strike price in an option contract?

The strike price is the fixed price at which the option holder can buy (for a call) or sell (for a put) the underlying asset. It’s a key part of the contract because it determines whether the option is profitable to exercise depending on the market price of the asset.

What is the difference between in-the-money, at-the-money, and out-of-the-money options?

These terms describe the relationship between an option’s strike price and the current price of the underlying asset. An in-the-money option (ITM) has intrinsic value (IV) - for a call option, IV means the asset price is above the strike price; for a put option, it’s below the strike price. An at-the-money (ATM) option’s strike price is very close or equal to the current asset price, meaning it has little or no intrinsic value. An out-of-the-money option (OTM) has no intrinsic value - for calls, the asset price is below the strike price, and for puts, it’s above the strike price. These distinctions affect the option’s price and likelihood of being profitable.

Can options be exercised early?

Yes, some options can be exercised early, but it depends on the type of option. American-style options can be exercised at any time before expiration, giving the holder flexibility to act early if it’s beneficial. European-style options, on the other hand, can only be exercised on the expiration date itself.

How can I use options to hedge my stock portfolio?

You can use options to protect your stock investments from potential losses. One common way is by buying put options, which give you the right to sell your stocks at a predefined price. If the stock price falls, the puts increase in value and help offset the losses in your portfolio. This strategy acts like insurance, reducing risk while still allowing you to benefit if the stock price rises.

What is the time value of an option?

The time value of an option is the extra amount a buyer pays above option’s current intrinsic value, reflecting the chance the option could become more profitable before it expires. Basically, the more time left until expiration, the higher the time value, because there’s more opportunity for the price of the underlying asset to move in your favor. As the expiration date gets closer, the time value decreases and eventually drops to zero.

What are the different types of option settlement and how do they work?

Options can be settled in two main ways: physical settlement and cash settlement. Physical settlement means the actual delivery of the underlying asset when the option is exercised, such as transferring shares to the buyer in a call option. In contrast, cash settlement involves no delivery of the asset; instead, the parties exchange the difference between the strike price and the market price at expiration.

What type of option settlement is used on XTB’s platform?

All options available on XTB’s trading platform are settled exclusively in cash, meaning no physical delivery of the underlying asset occurs. Instead, the difference between the strike price and the market price is calculated, and the resulting amount is credited or debited to the trader’s account. This approach simplifies the settlement process, eliminates the need for asset transfer, and ensures efficient handling of positions