Introduction to Options Trading

People use options as a means to bet on the direction of a stock. Options generally require less of an initial investment and have more leverage than stocks. The following options tutorial was created to help you understand exactly how they are used an investment vehicle.

Table of Contents
Chapter 1: Introduction to Options Trading
Chapter 2: Options Trading Terminology
Chapter 3: Option Trading Strategies
Chapter 4: Types of Options Trading
Chapter 5: Common Applications of Options Trading
Chapter 6: How to Trade Options

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Chapter 1: Basics of Options
Illustration of a Simple Option
Key Aspects of Options
Calls and Puts

Chapter 1: Basics of Options

An option is a security with some unique characteristics. It is traded much like stocks but there are some significant differences between the two.

Put simply, an option is a right to buy or sell an underlying asset, like the stock of a company. The holder of an option can choose to use his option to make a purchase or sale of the asset at a specified price within a specified time period.

The option gives him the right to carry out these trading activities at pre-determined terms but do not impose an obligation to buy or sell. In effect, the holder can either use the option before the time it expires or choose to ignore it.

Options are based on a contract between two parties who have opposing views on which way the price of an asset will move. When used correctly, they can act as a very powerful tool for investors. The amount of flexibility that they offer means that you can easily combine multiple options to create highly complex trades that fulfill a very specific investment objective.

For example, you can create an option combination to bet that a stock will not move outside a particular range or the other way round (referred to as a straddle).

Just like any other security, an options contract comes with its own clearly defined terms, conditions and price. It is as legally binding as any other investment.

Illustration of a Simple Option

The concept of options can be understood easily by using an example. Company A is a start up, which is on the verge of launching a great software product. There is no guarantee that the product will be successful.

But a smart investor who has a good idea of the applications of this particular product can choose to gamble that the company will reap the rewards of its successful product some time in future, say a year from now.

His guess is that if the product is launched and is in great demand, the company’s prospects will improve. The shares of the company will grow in value from the current levels. To take advantage of this future expected increase in prices, the investor can purchase an option, which allows him to buy shares in the company at a price close to current levels.

If his guess is correct and the company’s share prices go up significantly, he can exercise his option to buy the company’s stock at a price level much lower than the current market price. He can then sell these shares immediately in the market to make substantial gains from the difference between purchase and sale prices.

In case his prediction fails to materialize and the company’s shares either remain at the same price level or fall to a lower level, then he can choose to simply ignore the option. His net loss is limited to what he paid for the option, which is much less than what he would have paid for actually buying the shares.

Key Aspects of Options

An option has some special characteristics:

  • It gives the holder the freedom to buy or sell the asset at his discretion at terms which have already been determined at time of the creation of the option. This gives him a lot of flexibility in adapting his investment strategy to match current market conditions.

  • Options are highly speculative and the holder basically makes a gamble on how the asset will fare in the future. The speculative nature of the option and the inherent safety net that it provides allow investors to make large risky bets without putting a lot of money at stake.

  • To trade in options, an investor needs to have a good understanding of the markets. The most important skill to be successful in options trading is an ability to guess which way the market will go and this comes with experience in investing.

Like with any other kind of investing, the risk with options trading can be reduced by tempering your speculations with a dose of caution.

Calls and Puts

An option holder can purchase an option to buy or sell an underlying security. The holder of an option to buy has a ‘call’ option, while a sell option is referred to as a ‘put’ option.

  • Calls: The call option holder can buy the asset at the price mentioned in the options contract within the time specified in it. The holder speculates that the asset will grow in value within the time period of the option. At the end of this period, he hopes to be in a profitable position because of his right to buy the stock at a low price. The holder of a call option is said to have a ‘long position’.

  • Puts: The put option holder is said to have a ‘short position’ on the underlying stock. He can sell the stock within the option’s time frame at the price mentioned in the contract. The put holder believes that the share price is set to fall during the option term. He hopes to make a profit by selling at a higher value than he can get by selling in the open market. A put option is good way to protect your investment from any risk of decline when the economy is volatile.

Next Chapter: Options Trading Terminology