Learn Options Trading
Learn Options Trading – Basics & Review
Perhaps among the most complicated and possibly the riskiest type of trading is option trading. Most seasoned traders realize that option trading does not suit all traders. It selects its own type of people, usually the risk takers. And the trade itself requires skills and thinking unique only to people who could handle extreme risks. Most experts recommend this type of trading only to those people who have sufficient risk capital as it carries with it substantial risks.
By nature, it is also speculative. So if you are a person who doesn’t want to speculate too much, you might as well find another type of security which will work best for you. However, rejecting the idea of entering this trade right away is as risky as not knowing anything about it. It carries with it risks, that’s true, but it is also a highly profitable venture. You might as well try to learn something on it such that you could decide whether to try you luck on options trading or not.
While it is inherently risky, option trading also offers advantages that may not be had with other types of trades. Among its premium advantages is the flexibility it lends its investors. Each lender has the option to trade at a specific price within a predetermined period.
It is also, by comparison, a more advantageous type of trade because of the high leverage it offers. Depending on the location, each option may cover a number of underlying assets. In the United States, for example, each option may represent for 100 underlying assets. Thus, this principle lends the holder the capacity to profit from several assets within a single option.
So what is an option?
An option is a type of security, perhaps closely comparable to bonds and stocks. It is, in itself, a binding contract, that is monitored by and through strict terms and conditions. In gist, options are contracts that owners could buy or sell at a certain price prior to or on a specific date. An option is typically an added price tag to a certain asset or item because it is a reservation for the purchase or sale of a certain asset.
Options are also sometimes called derivatives. This is due to the fact that the value of an option is derived from the value of the underlying asset.
Options Trading Facts :
1. Options give the investor the right to buy or sell the underlying asset or instrument.
2. If you buy options, you are not obliged to buy or sell the underlying asset, you just have the right. Meaning, you can choose to buy the options, sell the options or do nothing and let it expire, depending on what is most advantageous to your position.
3. Options are either call or put. Call options give the power to the buyer to buy the options. Put options give the buyer the right to sell the options.
4. Options are quoted per share, but are sold in 100 share lots. Meaning, if the investor purchases 1 option, he or she is buying 100 shares.
5. The investor only has to pay the option premium and not the total amount of shares like if you are buying per stock. For example, if the option premium of a $50 stock is $3, the total amount of the contract is $300 per option. So if the investor is buying 3 options at $3 per option, since he or she is buying in 100 share lots, the total payment would be $900 (3 options x 100 shares per option x $3 option premium).
6. Buying shares is different. You have to pay per share. For example, the stock price of Company A is $80. If you want to buy 100 shares, you would have to pay $8,000. Whereas with options, if you wish to invest on 100 shares, you just have to enter into a contract wherein you would buy one option at a certain option premium.
7. If you wish to buy the stock at the end of the contract, that will be the only time where you will pay the total amount of money that is equivalent to the number of option contracts, multiplied by contract multiplier. Refer to #6 for example.
8. If the buyer exercises his rights to buy the option (call), the seller (or the writer) is obliged to deliver the underlying asset.
9. If the buyer exercises his rights to sell the option (put), the seller is obliged to purchase the underlying asset.
10. If the buyer wishes to exercise his rights to either buy or sell the underlying asset, the seller must either sell it or buy it at the strike price, regardless of the its current price.
11. In case the buyer of the option decides to do nothing at the end of the contract for whatever reason, the seller keeps the option premium as profit.
12. In computing your profit, you have to consider 2 things: the option premium and the strike price. If the option premium is $2 and the strike price is $50, your break-even point is at $52. So in order for you to make a profit, the stock must be more than $52. If the stock falls below $52, say $49, and there is no time left, you won’t lose $3 per stock. What you will lose, however, is the option premium you have paid for the contract.
Note: The numbers were just picked out of the air to illustrate how options trading work. In real world, numbers vary widely so you have to carefully study each of them.
Option Trading Important Terminologies
Although there are hundreds of terms that are used in the financial language, beginners have to understand first the most important and commonly used words.
Option – is the right of the buyer to either buy or sell the underlying asset at a fixed price and a fixed date. At the end of the contract, the owner can exercise to either buy or sell the option at the strike price. The owner has the right to pursue the contract but he or she is not obligated to do so.
Call option – gives the owner the right to buy the underlying asset.
Put Option – gives the owner the right to sell the underlying asset.
Exercise – is the action where the owner can choose to buy (if call option) or sell (if put option) the underlying asset or, to ignore the contract. If the owner chooses to pursue the contract, he must send an exercise notice to the seller.
Expiration – is the date where the contract ends. After the expiration and the owner does not exercise his or her rights, the contract is terminated.
In-the-money – is an option with an intrinsic value. The call option is in-the-money if the underlying asset is higher than the strike price. The put option is in-the-money if the underlying asset is lower than the strike price.
Out-of-the-money – is an option with no intrinsic value. The call option is out-of-the-money if the trading price is lower than the strike price. The put option is out-of-the-money if the trading price is higher than the strike price.
Offsetting – is an act by which the owner of the option exercises his right to buy or sell the underlying asset before the end of the contract. This is done if the owner feels that the profitability of the stock has reached its peak within the date of the contract.
The Benefits of Options Trading
It is easy to dismiss the benefits of a trade if the most typical description attached to it is risk. But it should not be so. There are great benefits that may be taken from participating in options trading that most people overlook. One should take into account that all types of trades have inherent risks but they also offer advantages in return.
Flexibility
Although it is true that options trading may not fit everyone, it still does not change the fact that to those traders who have made this trade work for them, it is clear for them that options offer great flexibility for both the option buyer and the seller.
Most types of trading do not allow profiting from the underlying asset. However, with option trading this is very possible. There are various strategies traders use to maximize this advantage.
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