Sunday, 14 December 2014

What is Options Selling?

To understand option selling, we need to understand what are options?

Options are contracts that allow the holder the right to exercise (buy or sell) the underlying asset at a specific price on or before a specific date for a premium. Common uses of option in daily life include buying a house or buying insurance.

For example, you pay the insurance company to insure the underlying asset (which could be you, your property or anything else) at a specific price (how much the insurance will pay in the event something happened)on or before a specific date (the duration of the insurance policy) for a premium (money that you pay monthly or annually).  If you fail to pay the premium then the policy will expire. But if something happens, the insurance company would have to pay.

The above example is typical for option buyers. Then, if you think about it, if there are buyers (policy holders), there has to be sellers (insurance company) out there.

Option Selling can be compared to being an insurance company for the financial world. You take on the risk for a small amount of premium. Who in the right mind will want to take on the risk? Well, think about it, most of the time you have insurance but how often do you make a claim? When no claim is made during the policy year, the premium will still be kept by the insurance company. Most insurance will either charge a higher premium or deny the application for those with a higher risk.

The most interesting part is this… you can choose to exit the position anytime you feel uncomfortable. You just have to buy back the contract and you close the position. Risk is always there, it’s how you manage it that defines your portfolio.

Investing Wolf
Disclaimer: This is not a recommendation to buy or sell any mentioned stocks or securities in this blog.

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