Posted on 08 August 2011.
Before using options as a tool for investing in the stock market, it is vitally important to first understand option trading basics, such as: what is an option?, what kinds of options can be traded?, how are options traded? Understanding option trading basics will help an investor make sound investment decisions when utilizing options as part of a trading or investing strategy.
An Option is a financial product that is comprised of a contract to buy or sell a specific amount of the option’s underlying instrument (which is a stock or commodity) at a specified price on a future date.
An Option contract to buy a specific amount of the option’s underlying instrument at a specified price on a future date is known as a Call Option.
An Option contract to sell a specific amount of the option’s underlying instrument at a specified price on a future date is known as a Put Option.
An understanding of option trading basics is not complete without an understanding of how investors use options in their investment and trading strategies. Investors use options for a variety of reasons, including: speculating that a stock is going to make a move higher or lower, locking in their gains on a stock that they hold that has made a significant move higher, and collecting a premium on a block of stock that they own.
Many investors use options to speculate on price moves in stocks. An investor would buy a call option to profit from an anticipated move higher in the price of a stock. The higher the move above the target price (strike price) for the option before the expiration date, the higher the profit is for the buyer of the call option. The opposite formula is used for put options. An investor would buy a put option to profit from an anticipated move lower in the price of a stock.
Investors also use options to lock in or insure in their gains in a stock by buying put options in sufficient amounts to cover their stock holdings near the current trading price of a stock. If the stock falls in price, then they can still sell their holdings in the stock at the put option’s target price, thus locking in their profit at a specific price regardless of what happens to the stock.
A stockholder who owns a stock that wants to make some money off of their stock holdings without actually selling the stock can sell a put option and collect a premium from the buyer of the put option. Selling a put option can be risky, since the seller of the put option is relying on the stock to stay above the target price when the option expires. If the stock falls below the target price when the option expires, the seller of the put option may be forced to buy the underlying shares at the target price and provide them to the buyer of the put option, thus incurring a loss rather than making a profit from the premium that they collected for selling the put.
Options are also used in lieu of buying and selling actual shares in a stock because options are often much cheaper than the cost of actually buying shares of a stock, and therefore a trader or investor only has to commit a small amount of money to play a stock’s anticipated price movement.
Options are popular with some traders and investors because they protect a trader’s downside risk of playing an anticipated move in a stock’s price. If the stock does not move as anticipated, the loss associated with buying an option is limited to the premium (fee) that they paid to buy the option. Whereas, the loss associated with going long or short a stock can be substantial if the stock makes a significant unanticipated price move.
Those who wish to trade options are encouraged to go beyond option trading basics by learning as much as possible about the options market, which can be a very useful trading and investing tool.
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