By: Daniel Webb
This article attempts to set out the basic features that you will need to know in order to learn options trading. By the time you finish this article, you should understand what an option is, how they work and how you could potentially incorporate this into your overall trading strategy.
Back to basics
An option is a contract between the buyer (the “holder”) and the seller (the “writer”) that gives the holder the right, but not the obligation, to:
The subject of the option is whether to buy or sell an underlying asset.e. exercise the option) within a fixed period of time (i.e. typically before the option’s expiration date); and
Complete the above transaction within a fixed price.
As payment (consideration) for granting the option, the holder typically pays a premium to the writer (which in theory compensates the writer for the risk he/she has taken on in accepting the legal obligation/s that the option imposes on him/her). One potential financial “driver” that may encourage the writer to enter into a contract is the possibility that the option will expire prior to being exercised (allowing the writer to simply “pocket” the premium).
Therefore, the holder and the writer makes a “bet” effectively, the holder, hoping that the conditions of the market will change to his advantage for him to exercise the option, while the writer hopes that this will not happen.
While the option is “live” (i.e. the holder has a “long position” and the writer has a “short position” once the contract has been entered into, before it has been exercised or has expired.
Therefore, how does an option work?
There are two main types (depending on whether the option confers the right to buy or sell an underlying asset), namely “put” and “call” options.
“Put Options”
This is the time when the writer gives the holder the right to trade the underlying asset at the strike price before the option expires.
“Call Options”
It is where the writer gives the holder the right to purchase the underlying asset at the strike of its price before the option expires.
Various property can be the subject of an option, including securities, currencies, derivatives, indices and commodities. In a put option, the moment the contract is exercised, it is the writer’s obligation to fulfill the terms of the contract. (In the case where such property cannot be delivered (e.g. an index), cash is often used to settle the contract.
“Stock options” relate to the shares of a specific company. In call option, the writer needs to buy the underlying asset for the strike price. The term used to describe an asset in question is a “contract multiplier”, which is the multiple of the amount of the asset.g. groups of 100 shares.)
As above, all options have an “expiration date”, that is, a date after which they cannot be exercised. On the other hand, “European-style options” and “American-style options differs in a way as such, European style can only be traded on its expiration date, while the American style can be exercised anytime within the start of the contract to its expiration date. Most options used in the U.S. are style followed by Americans.
Some of the main types include exchange traded options (ETO’s) and over-the-counter options (OTC options). ETOs have standard form contracts and can be traded on public exchanges, whereas OTC options are typically bespoke and are traded between private parties (usually large institutions).
These are just some basic information one needs to understand to learn Options Trading. It is also imperative that a potential trader should grasp the advantages and disadvantages of various option types in seeking to formulate effective trading strategies.
Get more information and tips on options trading and grab some free ebooks and training by visiting my blog at http://www.savvyfinancialtraders.com
