Learn Options Trading the Easy Way

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

Option is defined as a con tract or an agreement between the buyer and the seller which gives the buyer the right but not the obligation to:

* Buy or sell the underlying asset which is the subject of the option (i.e. exercise the option) within a fixed period of time (i.e. basically before the option expires; and
Complete the above transaction within a fixed price.

The holder basically pays premium to the writer as its form of payment which counterweigs the risk in the part of the writer the moment the writer takes the legal obligation that the option imposes on him. The possibility that the option will expire prior to being exercised serves as a financil “driver” to encourage the writer to enter into contract.

So the holder and the writer are effectively making a “bet”: for the holder, that market conditions will change such that it becomes advantageous for him/her to exercise the option, and that he/she will then do so; for the writer, 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 of options which depends wether it confers to buy or sell an underlying asset, named as “put” and “call” options.

“Put Options”

This is where the writer grants the holder the right to sell the underlying asset at the strike price before the option’s expiration date.

“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.

Securities, currencies, derivatives, indices, and commodities are various properties which can be the subject of an option. 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 the case of a call option, the writer must purchase 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. However, there is a difference between so-called “European-style options” and “American-style options” in this regard: the former can only be exercised on the expiration date itself, whereas the latter can be exercised anytime between the commencement of the contract and the expiration date. Most options used in the U.S. are American-style.

Some of the main types include exchange traded options (ETO’s) and over-the-counter options (OTC options). ETOs can be traded on public exchanges and it has a standard form of contract, while OTC are bespoke and are traded between private parties usually involving 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

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