Learn option trading
As an investor, the choices that you have for investments these days are innumerable. There are mutual funds, stocks, and bonds etc. Options are a type of security too. They provide the investor with a variety of choices. But options are not just about this. Their specialty lies in their versatility. With options your approach could either be conservative or speculative. In addition you can also adapt yourself according to the needs of the situation. However, this versatility comes with a price. Options are described as complex securities. They can also be very risky. When trading with options you will often see a disclaimer that say that options are not for everyone and that they can be speculative and carry a risk for losses.
OPTION-BASICS
An option bestows upon the buyer the right to buy or sell. However it does not carry any obligation to do so. It is a contract, where an underlying asset can be bought or sold for a specific rate on a particular date or before the set date. A binding contract that carries strict terms and properties, an option is a security, similar to a stock or a bond.
OPTIONS WITH AN EXAMPLE
Let?s discuss options with this example. Let?s say you want to buy a house and are real excited about the one you just located. However you run short of cash and cannot mange to arrange for it for another 4 months. So, what do you do? You come to an understanding with the owner with the owner. You get a choice to purchase the house in another 4 months for $100,000. But then, this option brings with it a price. You have to pay $2000.
Now, let?s consider the two situations that could arise.
a) You tour around the house and you discover that it in fact the birthplace of Bryan Adams! The cost quadruples and Bryan Adams himself wants to buy it back from you. He is prepared to pay 10 times more than the amount you?d pay the owner. The owner is obliged to sell the house to you at the original cost because of the option and you make a fortune.
b) You go around the house and you finally realize that it is haunted. Not just that, half-a dozen genius rats also inhabit the house and that the walls are made up of only asbestos. Since you bought the option, you are under no pressure to go through the sale. But, on the flip side there is $2000 that is lost.
So, now you can understand options better. There are two primary features to be understood.
A) Getting an option means that you have the right but are not burdened with an obligation. The expiration date can simply pass by and you can let it go. At that point your option does not hold any worth. When you face something similar to this scenario, you part with all the money that you had put into buying the option.
B) A contract dealing with an asset is what an option is. This is also why options are termed derivatives. It simply means getting value from another source. The example mentioned above features the house is the asset that we are discussing and the option derives its value from the house.
THE CALLS AND PUTS IN AN OPTION
Two types of options are identified. They are calls and puts.
With a call a buyer can get an asset at a particular price. He can do it in a particular time frame.
With a Put, the asset can be sold at specified rates within a particular time frame.
THE OPTION MARKET PARTICIPANTS
Based on the positions taken in the stock market 4 participants are seen. They are:
1. Those who buy calls
2. Those who sell calls
3. Those who buy puts
4. Those who sell puts
Those who get the options are given the name holders and the writers sell them.
DIFFERENCES BETWEEN A BUYER AND A SELLER
a) As a call holder and a put holder (buyer) you do not have the obligation to buy or sell. You can also exercise your right, that?s if you choose to.
b) As a call writer and a put writer seller you have the obligation to buy or sell. Selling an option is thought to be more complicated. In fact for just this reason it could be a lot more risky.
WHY SHOULD YOU USE OPTIONS
You could use options for two important reasons A) for speculation, B) in order to hedge.
FOR SPECULATION
With options there is great advantage and that is why they are considered extremely versatile. You do not make a profit only when the market goes up. You could also make quite a sum even when the market goes down.
But options are called risky deals, why and how Well, you buy yourself an option you need to be precise, in finding out the direction of the stock?s movement. You need to know this, and also the magnitude and the timing of the movement. So, to make a profit, you should be in a position to accurately predict if the price of a stock will go up or down. In addition to that you must also be precise in quoting the amount of change in the price and the time limit in which all these changes will take place. You should also bear in mind the commissions.
WHAT IS HEDGING?
You could consider this function as your insurance policy. Quite similar to insuring your house, car etc., an option can also be insured, just in case the markets hit a low. Hedging can benefit both an institution and an individual investor. This way you can completely enjoy the full side of the market while the down side is controlled effectively.
A number of companies use stock options as an enticement to attract and retain talented employees. But such employee stock options are not available to one and all.
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