Option Trading Concepts

A stock option is a contract between 2 parties (a buyer and a seller) that gives a person (the buyer of the contract) the right, but not the obligation, to exercise the contract on or before a fixed future date (the exercise date or expiration) to buy or sell the underlying stock at an agreed price. For example, If you purchase a stock option for the right to buy the shares of XYZ company for $10 today, you can exercise that right to buy XYZ company's shares at $10 anytime in the future before the contract expires no matter what price XYZ's shares may be trading at that time. (Imagine that stock trading at $100 and you own the right to buy it for only $10!) Hence buying and selling stock options is not the same as buying and selling the shares itself. You are actually buying and selling the right to buy or sell the underlying asset at certain pre-determined prices.

Option trading is a risky and thus often very profitable and challenging business. Among the wide variety of securities that your portfolio can include there might be some place for options. But even if you are not going to take the risk participating in option trading it is useful to learn some basic option trading concepts at least to be able to decipher the talks on option trading matters that otherwise may sound misleading.

One of the good reasons to go into option trading is that it provides great opportunities to the option trading market participants. Here you can adjust to market behavior and profit being both speculative staking on stock or index advance, and conservative protecting your positions from decline.

Types Of Stock Options

There are 2 types of options - calls and puts.

Put option is an option contract that gives its owner the right (and not the obligation!) to sell a specific amount of the underlying security (usually, stocks) at an established price before the expiration of an agreed period of time. A put gets more valuable if the price of the underlying asset falls compared with the strike price, while the call option will give its holder the right to buy stocks at pretty much the same conditions. A call brings profit if the underlying grows in price.

In short, call options let the holder buy the underlying asset while put options allow the holder to sell them.

Besides, options sold on registered exchanges (listed options) usually come in two styles. These are American- and European-style options. American options can be exercised at any time before the expiration date, and European ones - at the end of their lives only. Options of the former type prevail on the national market of option trading.

Advantages Of Option Trading

LEVERAGE - Potentially an option allows you to make up to 10 times more money on the same move in the underlying stock versus simple stock trading! Even though option trading was not meant to be a leverage tool but a hedging tool, it is still a great way to profit while risking only very little money. The Leverage effect of option trading also allows an investor with very little money to participate in the move of a high priced stock as stock options cost only a fraction of the price of its underlying stock. Apple (AAPL) is trading at $93.65 today but it's call option costs only $1.70. Which means that an investor with only $170 can participate in the same move on Apple as would an investor with $9365 by buying its call option. That's another benefit of option trading.

PROTECTION - While option trading grants you leverage, it also grants you PROTECTION! When a stock moves AGAINST you disfavor ably, an option trader potentially lose much lesser than the stock trader. Why? Because your maximum loss is limited by the price you paid for the option which could be just 10% of the price of the stock! Taking our Apple example from above, the stock trader's maximum risk is $9365 while the option trader's maximum risk is $170 for controlling the same number of underlying stock. As stock options are meant to be a hedging tool in the first place, it is also a great way to protect your stocks from dropping in value by buying the same number of put options as the number of shares that you own. In this case, put options act as an insurance policy, protecting your shares from dropping in value.

FLEXIBILITY - Option Trading allows you to profit from every possible move in the underlying asset! Up or Down or Stagnant, there is an option strategy that allows you to profit from that move. An option trader can easily participate in a downwards move on a stock through buying a put option without having to risk margin calls by going short the underlying stock or futures.

Yes, there are even times when stock trading is riskier than option trading! This makes option our more preferred investment activity.