WHAT IS OPTIONS TRADING?

 An image of a stock options process chart.

 

If you have been thinking of investing in the stock market, options are a good choice. An option is a type of contract which gives the buyer the right to buy or sell an underlying asset at a specific price (strike price) prior to or on a particular date which is referred to as the expiration date. Options are securities, just like stocks and bonds, and come with terms and properties that are strictly defined. The buyer of an option has the privilege to exercise their option before or on the expiry date but is not obligated to.

Stock options are contracts between two parties: buyers and sellers. The people who buy options are called the holders and the ones who sell options are the writers. It gives the stockholder the option to buy or sell shares at or before a specific date. When you buy an option, you have the right, but not the obligation to buy or sell shares. This contract has very strict terms and conditions that must be followed by both parties.

Options give holders the ability to adjust or adapt their position when certain situations arise. However, it is important to understand that options have costs, they can be very risky and are quite complex in nature. They may not be suitable for all shareholders. Options trading can also be speculative in the sense that you expect certain movements on the market or index in order for you to make profits.

IF YOU WISH UNDERSTAND THE CONCEPT BEHIND OPTIONS THEN CONSIDER THIS EXAMPLE:

You are interested in buying something, maybe a second-hand luxury car or a valuable piece of artwork. Unfortunately, you do not have the entire amount required to pay for this right away. So you strike a deal with the seller, who agrees to sell the car or artwork to you after six months at a price of $40,000, provided you pay him $4,000 right now.

Now, suppose later on it is discovered that the artwork is much more valuable than you had initially appraised it to be; the owner is still obligated to sell it to you at the agreed upon price, regardless of this new value of the piece of art. On the other hand, if you decide that you do not wish to buy the car or the artwork (for whatever reason), you don’t have to, but you will not get the $4,000 you paid back. Buying an option places you under no obligation to go through with the sale.

Evidently, options are contracts that deal with underlying assets, meaning, they derive their value from something else. That’s why options are called derivatives. Going by the illustration given above, the underlying asset is the car or the artwork. Usually, stocks and indexes are the preferred underlying assets when it comes to options.

Understanding options trading contract lingo

To trade options, there are certain terms you need to understand. First, you need to know the difference between call options and put options. Call options give the buyer the right to buy stocks whereas put options allow the buyer to sell the underlying stock. The other common term is the strike price which is the amount required to purchase or sell a stock. The option premium is that amount that the option buyer has to pay the option seller to carry on the risk involved in the contract. Option contracts also have an expiration date. This is the date at which the stock option expires and becomes worthless. The month is usually specified on the contract and the specific date is set depending on the type of stock option you purchase. Stock options have an underlying asset which is simply the shares belonging to a specific company.

Call options vs put options

There are different reasons why investors buy these two categories of options. Since put options allow the holder to sell an underlying asset at a specified price, which is the strike price, you buy them when you think that the price of stock is likely to go down. On the other hand, investors will buy calls when they think that the price of stock is likely to rise and sell a call when they think it will fall. In more specific terms, with a put option, you are allowed to sell 100 shares of a stock at/by a specific date and specific price. So when you own a put option, you can easily lock in the minimum price of a stock. This means that if the market prices are higher than the strike price, you can still make a profit by ignoring the option and selling the stock at market rates.

In a nutshell, here is how you can profit from buying a put option. If you think that the price of a certain stock you own is going to go down, you can write a call option on the stock or buy a put option. This will ensure that you get a certain minimum price for the stocks you sell and still make a profit.

Benefits & Risks of Option Trading

Even though stocks are usually the most appealing to investors, there are a variety of financial instruments that present a wealth of benefits that stocks do not. A good example is options trading. This article explains the reasons why options trading can be a good investment and the risks involved in this form of investment.

Low capital investment

Options trading are suitable for small investors who may not have large sums of money to invest. You can have a very small investment and still make huge profits from options trading. Unlike most financial instruments, options allow you to generate sizeable returns from the small amount of money you put into the investment vehicle. If you are a good investor, you can take advantage of certain financial strategies to minimize the risk of taking certain positions in options trading.

Flexibility

One of the main reasons why so many investors are inclined to options trading lies in their flexibility. Options allow you to get a more regular return on your investment so that you can build your portfolio in the long term. It allows you to make safe investments that do not involve too many risks. Even though you may be getting a limited return, you will have minimized the level of risk considerably. There is also the option of taking more risk to earn huge profits. For those who are actively involved in trading stocks, options trading can allow them to make profits regardless of the condition of the market.

The other major advantage of options trading is that they allow you to buy and sell based on a wide range of underlying assets. The assets can be stocks, commodities, foreign currencies or indices. Whatever you want to speculate on its price, options trading gives you the opportunity to work with that. This means that you have a broader opportunity to make profits compared to when you are just trading stocks.

The risks of options trading

While the benefits of options trading are easy to identify, some casual investors may overlook the risks involved with this form of investment. Like all the other forms of investments you know of, options trading should not be considered a risk-free investment instrument.

One of the major risks of options trading lies in its complexity. It’s very important for someone to understand the strategies involved in this type of investment and if still new to options trading, consult someone with a huge amount of experience in this type of investment. Most beginners may end up making uninformed decisions that minimize their returns on investments.

We can say for a fact that trading options is no easy task. There’s certainly a lot that you will need to learn and this can be intimidating to some people which explains why many investors shy away from options trading. It does take a lot of time and dedication to understand how to really make profits from options trading. Take your time to understand how it works before you dive in.