Published On: Mon, Aug 12th, 2013

What is Option Trading?

what-is-options-tradingIf you’ve been trading different stocks for a while and are interested in something little more speculative, then you should consider options trading. At the basic level, any option traded on the stock exchange means “a right”. So option trading involves giving somebody the right to buy or sell a certain stock at a specific price and time. When you purchase an option to buy securities, then it’s known as a call option. If the option you purchase is for selling securities, then its’ known as a put option. In fact, some traders buy calls and puts on the same stock at an agreed price and date. It’s then known as a double option, or a put and a call option.

Still confused? The hardest part about options trading is to understand all this jargon. But once you are familiar with various technical names and instruments, you’ll discover that you just have to think which way stock prices will move in the near future. So once you have an idea on what’s going to happen, you just need to use the right option to make profits. For instance, if you are expecting that the price of a certain stock will increase, then you should buy a call option on that stock. This way, you can buy now at a much lower price, and sell later on at a higher price. Options trading will work if the stock price increases, but if it does not, you’ll be left holding a couple of worthless options. For put options, it works in the opposite way-you purchase put options if you feel that stock prices may fall in the future. In both these cases, you secure your option or right by paying some premium to the person selling the option.

The premium you’ll pay to the person selling the option is known as the option money. When market moves in an opposite way than you speculated, then you will end up losing just the option money you paid. Therefore, the best thing about options trading is that your losses will always have a known ceiling. So if you are not interested in risking large amounts of money, but still want to make decent profits from the price variations by investing small amounts of money, then options trading is best for you. But options trading is something you should dabble in only when you’ve spent considerable time learning about the stock market. It’s also important that you make your decisions calmly when the pressure is on.

Option traders enjoy several benefits. The biggest one is leverage. With leverage, the buyer can essentially borrow multiples of the underlying asset allowing them to make far superior profits if they are successful with their trade. The other benefit is protection. The buyer stays protected when the price of asset is low, and will lose a certain value of the original asset at a fixed agreed price. With the help of “put” option, the buyer can resell the original asset to the seller. Therefore, options trading comes with a built-in protection against volatile movements in the market.

All in all, options trading can be very profitable, but is not that easy if you are new to the world of financial investing/trading. It requires careful study of the markets and you should begin by taking calculated risks. It’s not for an uninformed investor!

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.