Trading Options – The Basics

You may have heard some of the talking heads on financial talk shows go on about trading options. You may also have been puzzled as to what it is they were actually talking about. The reality is, trading options is an alternative to trading bonds, stocks, and mutual funds. Like these securities, options are just one more component used to diversify and (hopefully) strengthen your portfolio

These are fairly complex securities that are often seen to be risky. In reality, options can be either more conservative or more speculative. Nonetheless, their complicated nature leads many to only invest with capital specifically designated for risky ventures.

To really understand trading options, forget the stock market mumbo jumbo. At their core, stock options relate to a very common sense principle. Purchasing an option gives you the right/privilege/opportunity, but not necessarily an obligation, to purchase a particular asset/“product” at a later date. Ergo, purchasing an option gives you…well, an option.

For instance, if you want to purchase an asset in four months, you can freeze the current price; make that purchase when the time comes for the locked in price, and potentially save money all by purchasing an option. An option, however, comes with its own price tag. Should the value of the asset plummet, you have no obligation to make the purchase.

You do, on the other hand, lose the money you spent purchasing the option. If the value of the asset is the same four months from now, you’ve essentially wasted the money spent on the option. If the price of the asset skyrockets—well then you’ve made yourself a pretty penny. And that’s exactly why many sophisticated traders employ options; the last scenario is fairly appealing. You just need to know what you’re doing, as the risk is evident.

There are two sides of the trading option equation. You can pursue a call or a put. With a call you profit from the asset price rising, and with a put you profit from the asset price falling.

It’s never unwise to learn some of the technical language used in trading options. You already know what an option, call, and put is, but what about the other features of this unique security? Using the example above, the locked-in price, or the frozen cost, is referred to as a “strike price” in the industry. Fluctuations above or below the strike price determine profit and loss. All buying and selling (exercise of options) must happen before the expiration date of the option (the 4 months in the above example.) The price paid for the option is called the premium, this is a flat rate exchanged at the time of purchase.

Options are interesting, useful securities that after plenty of research and contemplation can be rewarding and lucrative.

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