Trading calls and puts is not as cut and dried as stock trading, and without a basic understanding of options and the related terminology, it can be virtually impossible.
Unlike stocks, options offer the right to either buy or sell a stock, commodity, or other financial instrument at or by a future date.
Essentially, an option can be considered a promissory note a buyer, also known as a holder, issues to a seller, known as a writer, stating that he may purchase the instrument in question at a later date.
It is important to note that the buyer is not obligated to fulfill the option contract, as opposed to futures contracts, which obligate both seller and buyer.
Call options give the right to take a long position in a certain asset, in other words to buy it, while put options offer the right to take a short position at a certain price on or by a certain date agreed upon by the two parties.
The asset that is to be bought or sold is known as the underlying, while the exercise or strike price is the price at which the asset in question will be delivered if either party decides to fulfill the contract.
Options are derivatives most often used to either leverage or hedge trades or investment portfolios but they can also be effectively traded on their own.
However, they are preferred as a risk management tool for the simple reason that most traders do not understand options and attempt to trade them as they would stocks.
This is a recipe for disaster as stocks are affected by fewer variables and a rise in stock price can still lead to a loss if one is trading options.
Trading Calls: Covered or Uncovered Call options can be either covered or uncovered.
Covered call options are those contracts where the investor owns the underlying asset while uncovered options imply that the underlying stock is not owned.
Trading calls can be much riskier than trading stocks if one doesn't understand how options work.
For example, if one sells a covered call at a certain price and the price of the underlying asset rises by the expiration date the writer will be forced to sell if the holder decides to exercise his rights.
On the other hand, if the price drops then the writer will earn the premium.
Trading calls that are uncovered is an even riskier proposition if one is selling.
Selling an option where the underlying asset is not owned puts the writer in difficult position.
If the holder decides to fulfill the contract, either because the underlying asset's price has risen or for any other reason, then the writer will have to purchase the asset on the open market to fulfill the option.
It may be one way to increase liquidity but the associated risks are usually not worth it, especially for an inexperienced trader.
Buying calls is, basically, leveraging as it allows an investor to purchase assets for only a premium with the balance being due only when the contract is fulfilled.
A call option purchase is usually a short-term position as an investor will buy when expecting the price of the underlying to rise.
The investor will then sell the call for a profit.
The advantage of trading calls over stocks is that due to leveraging profits can be exponentially higher on the same trade.
However, the risks involved are also much greater because by leveraging one can lose much more than their investment.